Understanding interest rates on a credit card is harder than it seems. What is the real interest rate? How often is it applied, and what does it really cost? Credit cards are usually advertised by their APR (Annual Percentage Rate). What does a credit card apr mean?

Defining Credit Card APR and Its Impact on Credit

Interest rates are the cost of having access to a credit line—it’s the fee you pay for borrowing money from the bank instead of your own. The longer you owe in credit card debt, the more it will cost you in interest and affect your credit history..

Credit card apr refers to the yearly interest rate on a card. But it’s not quite that simple. Interest is typically calculated every day, and you are charged every month. The “annual” rate is not something you’d ever pay, because if you only paid once per year, you’d have lots of late fees on top of the balance and interest. Having an outstanding balance every month will also have a negative effect on your credit history.

Consequences of Late Payments and Default

Besides late fees, paying once per year means the debt would have defaulted after months of nonpayment to the credit card account and probably has been transferred to a collection agency, severely impacting your good credit score in the process.

How Does Credit Card APR Work?

Calculating Daily and Monthly Interest Rates For Credit Card Debt

The average card APR in the US last quarter was 17.13% (according to the Federal Reserve). If you owed an outstanding balance of $1,000 in credit card debt, what would that APR really cost you?

First, you divide the annual percentage rate by 365 to come up with a daily rate. So .1713 ÷ 365 = .000469315. That is the percentage of interest you’d be charged each day.

Confused yet? You also have to remember that the balance is good throughout a monthly billing cycle. So on day 1 of the month you owe $1,000 on a credit card with 17.13% interest.

Then you are charged approximately.47¢ in interest. ($1,000 x 0.000469315% daily percentage rate).

Then the balance on the credit card for day 2 is $1,000.47, and the balance on day 3 would be $1,000.94, and so on. By the end of the month, you’d have a balance of $1,014.28 owed to  
The card issuer.

If your debt is compounded monthly, starting on day 1 of month 2, you’re charged.000469315% of the new higher balance.

That’s assuming you didn’t use the card at all during the month. If you did, you might increase the interest charged every day, because many credit card companies base your interest on your average daily balance. So if you spent $30 on top of the $1,000 you started with, the average daily rate would be $1,001, and that’s what your daily periodic rate would be charged against.

Grace Periods

Advantages of Paying Off During the Grace Period

All of this complex calculation can be debatable if you pay off credit card purchases quickly. Credit cards may have a grace period, wherein you are charged no interest if you pay off the balance in full. Usually credit card issuers give a range of 21-30 days.

If you use a card all month long and pay it off completely before the billing cycle's due date, there is no interest charged, and you’ve essentially gotten to use the credit for free. There is no grace period for cash advances, so interest starts adding up as soon as the transaction is completed. Unfortunately, this is true even if you pay your whole debt and begin the payment cycle with a zero balance.

This is a great way to use credit cards. You get the benefits of convenience, security, and the ability to use your credit card transaction history for budgeting purposes. You also earn potential card features like premium rewards, cash rewards, lost luggage insurance, complimentary access to private entertainment events, travel rewards, hotel credit, and also the positive credit history associated with using your credit card responsibly. 

If you pay off the charges before the grace period, you are charged nothing extra for all of these benefits. Go one day past the grace period, and then all of those interest charges kick in and you’re charged for the whole month, calculated against your average credit card balance.

Interest on Cash Advances and the Importance of Timely Payments

When it comes to cash advances, there is no grace period. That means interest on cash advance APR starts adding to the balance immediately. Even if you pay off the balance before the billing cycle, you still end up with some interest charges

By avoiding cash advances and paying off your credit card in a timely fashion, you can keep your credit utilization rate lower, improving your score. Also, avoid late fees and late payments; these two will lower your score.

Compounding

Understanding Compound Interest From Card APR

The full answer to the question of how does card APR work includes compound interest. The math of credit card APRs is tricky. Credit card issuers may compound interest daily or monthly, and this will change the calculation.

What this means is, you are paying interest on the extra debt you incurred yesterday through interest? Sometimes the “real” interest rate is calculated to include compounding, and is called the effective annual rate, or EAR. Wikipedia has an example with an account with an average card APR of 12.99% that becomes 13.87% when compounding is considered.

Fixed vs. Variable APR

Differences Between Fixed and Variable APR and Their Impact

If the math isn’t confusing enough, some cards APRs change every month. A fixed APR is going to stay the same, unless something major happens, like you ask for a reduced rate from the creditor, or a low introductory rate expires. A variable APR is often tied to prime rates.

The Prime Rate (Variable APR), usually based on the federal funds rate set by the Federal Reserve, is currently 3.25%. So a credit card might have an interest rate of 10%+ prime, giving you a rate of 13.25%. If the prime rate goes up, so does your credit card rate.

For more about these rates and other kinds of interest, see our article and infographic “What Does That Interest Rate Really Mean?”

Different APRs for different balances

Exploring Various APRs Based on Transaction Types

To add more complexity to all of this, you might have different APRs depending on what kind of balance you incurred. You might have a purchase APR that is charged on balances incurred through regular shopping, dining, travel, etc. This is usually the card purchase APR you see advertised.

Then there will be a different cash advance APR. This is usually much higher than the purchase APR. 

Then you might have a lower interest rate APR for balance transfers, to incentivize you to move balances from other cards to a different lender.

Penalty APR might kick in if you miss payments, go over your credit line limit, or make a credit card payment that is returned for some reason. This rate is much higher than your regular APR, and can reset a low introductory rate. You’ll need to make payments on time for six months in a row to get your rate reset back down to the regular APR.

All of this is complicated, and every credit card agreement is different, so your real interest charges will depend a lot on the fine print of your agreement and your needs for borrowing money, spending habits, and repayment behavior.

What Does APR Mean On a Credit Card?

Key Points to Understand: Critical Aspects of APR

• APR is a rough snapshot of the interest you would pay annually, but the real percentage is going to be higher due to compounding.
• Interest is charged monthly, not annually, and may be compounded daily or monthly.
• Grace periods allow you to pay off credit cards and avoid interest charges altogether.
• You’ll have a different APR for different kinds of balances, like cash advances, balance transfers, and purchases.
• Interest rates might change under certain circumstances. Read the credit card agreements before applying for a card to know what might change your APR.

There is no need to carry a balance; your credit history will benefit from positive repayment habits. It’s a common credit card myth that many people believe it’s necessary to carry a balance over from one month to the next to help them build credit, that’s incorrect and could be costing you money. 

The best way to respond to a high Annual Percentage Rate is to pay off the card in full each month and reduce your borrowing. If all the APRs you’re being offered seem sky-high, talk to our credit counselor about what you can do to improve your credit and qualify for better terms.