Balance transfers, cash advances and purchases typically have different APRs. Card issuers apply payments to lower interest rate balances first.
Dear Credit Guy,
Could you explain how an annual percentage rate works and its definition in the most laymen’s language? What is the key thing to lowering my APR?
Absolutely! KISS or (Keep It Simple Stupid) should be my middle name. The annual percentage rate or APR is a financial term that is used by lenders to let you know how much interest you are being charged on a yearly basis for your loan. For example, on a $10,000 car loan at an 8 percent APR you would pay approximately $800 in one year in interest for the loan. I use the word approximately because most loans charge interest on the balance of the principal amount due, and that amount changes each month when you make a payment, which is a good thing. A lower unpaid balance means less interest the lender will charge resulting in positive amortization.
Here’s an example of how your monthly payment affects the amount of interest you pay on a $10,000 loan with a 48-month repayment period at 8 percent interest:
|Month||Monthly payment||Principal paid||Interest paid||Remaining balance|
Using the chart above, you can determine how the amount of interest charged was calculated by taking the remaining balance and multiplying it by 8 percent and then dividing by 12. The total interest paid for the loan described above would be $1,719.
APR is fairly simple for the fixed-rate loan example that I used above. It gets somewhat more complicated with outstanding credit card balances. The reason is because you may have several different APRs on one credit card account. For example, you may have an APR for balance transfers of 1.9 percent, an APR for purchases of 12 percent and a much higher APR of around 25 percent for cash advances.
Just how much the different APRs affect the amount of interest you pay depends on how your payments are applied by your creditor and whether you have balances in each different APR category.
Here’s an example of how interest is applied to a credit card balance with different APRs. Total credit card balance of $5,000 (including a $3,000 balance transfer, $500 in purchases and $1,500 in cash advances) with a monthly payment of $300 per month:
|Balance||APR||Interest charged||Payment applied|
As you can see from the above example, when you have several APRs on the same credit card account, the majority of your payment will likely be applied to the balance with the lowest APR. I recommend you check your credit card statement carefully to determine how your payment is being applied.
The key ingredient to getting the best possible APR for any loan is to have your credit in the best shape possible. In order to do that you must know your credit standing. Get copies of your credit reports from each of the three major bureaus and purchase your credit score from MyFico.com and VantageScore.
Once you know how good (or bad) your credit history is, you will have a good idea if the APRs charged on your current loans are what you should qualify for with your credit history. If the APRs are higher than they should be given your credit standing, call and ask to have them lowered. You can simplify the math on figuring interest charges on your credit card accounts by paying off the balances in full each month — easier, and less expensive — by using this calculator.
Take care of your credit!