How Credit Card APR Really Works
Don’t let high interest rates drag you down.
So you know that your credit cards have an assigned interest rate. Hopefully you also know that whatever rate you’re being charged, it means that your purchases cost more over time with interest added.
But do you really know what that means for your debts and for your budget?
Becoming an APR expert will help you avoid credit card debt problems so you can truly control your financial life. Here’s everything you need to know to get ahead…
Fact: As of the end of 2011, the average credit card
APR for existing cards in the U.S. was 12.78%.
What is APR… really?
Credit card APR is the interest rate charged on debts you accrue from putting charges on plastic. The higher the APR, the faster interest builds.
To talk technically, APR is the “annual percentage rate” that gets applied to your debts. That actually includes interest and fees that apply every calendar year.
By contrast “periodic interest” is the interest rate applied to your debt each pay period. For most people, the pay period is a month, so if you take your APR and divide it by 12, that’s the interest charged on your debt at the end of every pay period.
If you have $1,000 on a credit card with 15% APR, how much interest will the interest charges be on your next bill?
(15% APR ÷ 12 months) x $1,000 = $12.50 Your minimum payment would be $20, so more than half of the money you pay goes to interest charges.
Different types of credit card APR
APR doesn’t just come in one flavor. In fact, most cards have a few different rates that can be applied to your account, depending on the type of activity on your account and a few other factors. Knowing when these rates get applied helps you plan ahead in how you pay back what you owe.
- APR for Purchases: This is the standard APR that gets applied to your debts when you make normal purchases with your credit card.
- Introductory APR: This type of APR gets applied for a limited time right after you open an account. It’s usually much lower than the standard APR for Purchases in order to entice you to sign up for a card.
- APR for Balance Transfers: This type of APR gets applied when you transfer the balance from a higher interest credit card to this card. This rate is important to note if you’re looking into DIY debt consolidation.
- APR for Cash Advance: This type of APR is applied when you take out a cash advance on your credit card. It is another type of transactional interest rate.
- Penalty APR: This is what creditors apply when you are late or miss a payment, pay less than the minimum amount required, or exceed your credit limit. It’s usually significantly higher. Terms vary on how long penalty APR can be applied, although most creditors will restore your normal rates after six consecutive on-time payments.
APR and minimum payment requirements
Your minimum monthly payments are typically calculated either as a small percentage of your debt (usually between 2%-5%) or using a formula that adds the monthly interest accrued interest to 1 percent of your balance.
In any case, most of what you pay each month goes to paying off the interest. Very little is used to reduce principal (the original debt owed). As a result, your balances decrease slowly, which means you stay in debt longer and pay more in interest.
In the Pop Quiz example the interest paid in that month was $12.50. In general, the minimum payment requirement will be anywhere from $20.00 – $30.00. So about 40% – 60% of your payment is going to interest. Even though you paid more, you only pay off $7.50 – $17.50.
The issue of high debt & high interest
So even in good circumstances, if you’re only making the minimum payments on your credit cards, then most of your payments are going to interest charges. But the situation is worse if you have a lot of debt – and the problems are only compounded if you miss a payment and penalty interest gets charged.
If you have $7,500 on a credit card with 19% APR, how much interest will you pay before you eliminate the debt if you just make minimum payments on a 2% payment schedule?
a) About $5,000
b) Around $10,000
c) Around $15,000
d) More than $25,000
If your minimum payment schedule is 2% of your balance, then you will pay $26,397.73 in interest charges before you eliminate the debt!
d) More than $25,000
So you’re actually paying more than three times the original debt in added interest charges! What’s worse, 19% isn’t actually a very high interest rate for penalty APR. If your penalty APR goes up to around 30% (which is pretty common), then you may end up making payments but watching your balance go up because you’re not even paying off all the interest accrued in that month.
How is it even possible to get ahead?
Simple: you pay more than the minimums. The more you pay each month, the more of the actual debt you eliminate.
So from the original example, if your interest charges are $12.50 and you make the minimum payment, then most of what you pay goes to interest. But if you pay $100, then you’ve shaved a nice chunk off the original debt.
With that in mind, you should strategically plan how to pay off your credit cards. Using a debt calculator to plan out your payments can help.
If your interest rates are too high to make progress with bigger payments, then you also need to consider consolidating to reduce the interest rate. This is vital, because when you lower the interest rate, more of your payments go to eliminating the actual debt.