What is APR and how does it work?

Almost everywhere you look you’ll see the term APR – on credit cards, cars, loans, and even sofas. But what is APR? How does APR work on a credit card? What is an average credit card APR?

Knowing what APR means, and how it works for you and against you, is vitally important before you use a credit product.

What is APR on credit cards?

APR stands for “Annual Percentage Rate.” The APR is the amount of interest you will pay on an outstanding debt per year, plus standard fees and charges like an annual fee if one is charged. If you owe £1,000 on your credit card, you have an APR of 20%, and you just leave that debt there for a year, you would pay £200 in interest, excluding any annual fees the card charges. Premium rewards credit cards may have high APR because the amount includes an annual fee.

If you have a £5,000 personal loan with 5% APR, you would pay £250 in interest per year. If you’ve got a £10,000 car hire purchase agreement with 15% APR, you would pay £1,500 per year in interest.

What is an average APR rate?

When you apply for a credit card, one of the first things you should notice is its APR – be it high (as high as 35% on a bad credit credit card) or low (as low as 0%). Most “normal” credit cards have an APR of around 20%.

APR can vary wildly between credit cards and card issuers, but generally it depends on the type of card and your credit score. If you have a bad credit record, you will likely have to make do with a high APR because the card issuer views you as a higher risk. If you have a great credit score, you’ll have access to low-interest cards and even cards that give you 0% APR for a long period of time (up to 36 months!).

No matter the APR, though, you only ever pay interest if you have an outstanding debt. If you pay off your credit card every month (which you should!), or you pay off a personal loan early, you would pay no APR.

The different types of credit card APR

With loans and hire purchase agreements, APR is straightforward. Credit cards are a bit more complex and can have different types of APR that you need to be aware of.

There will usually be a headline rate of APR, which describes how much interest you will pay when using the card as it was designed to be used. For example, 0% APR on purchases means you’ll get 0% APR only on purchases. 

For everything else, such as cash advances on the credit card, or balance transfers, there could be a high APR to watch out for.

If you look through a card’s small print, here are some types of APR that you might see:

What does representative APR mean?

You will nearly always see the word “representative” before the word APR. This is because not everyone who applies for a credit product gets the advertised rate – usually because their credit score isn’t good enough to qualify for the APR, or the lowest APR is only available on loans up to a certain amount.

Credit providers must give the representative APR to at least 51% of people who are accepted for the credit card or loan. This means the majority, but not all of those accepted for the credit product will receive the representative APR.

If you’re accepted for the credit product but not in the 51% majority, you will be offered a similar card or loan with a higher APR – or perhaps a shorter 0% promotional period.

All advertised representative APRs will have an assumed credit limit of £1,200. This is so you can easily compare one credit product to another. The actual credit limit you are given may be higher or lower than this, depending on how the credit provider deems your creditworthiness. This credit limit isn’t offered to 51% of approved applicants - it is just for comparison purposes.

In practice, you must be aware that the credit card or loan offered to you may have a higher interest rate than the APR on a website or marketing materials. Never base your personal finance budgeting on the representative APR – wait and see what APR the credit issuer actually gives you.

Why you should care about APR

Long and short: Credit card and loan providers need to make your business worth their while, and APR is the way they do it.

That said, especially when it comes to credit cards, paying APR is not inevitable: not only are there a host of 0% interest credit cards to choose from but so long as you clear your balance you won’t incur APR expenses at all.

At some point in your life, though, you might end up paying interest on your credit card balance. Late payment fees, plus the force of compound interest, can quickly result in debt that’s hard to clear.

It’s very hard to predict when you’ll hit one of life’s potholes. As always, our advice is to be prepared and practice good financial hygiene, even if you don’t think it’s necessary. Be a good borrower. Pay off your balance every month, and look out for low (or no) APR cards that keep you protected in the off chance you don’t.

24 November 2020