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How do credit card APRs work?

An explainer of APRs, including what they are, what products have them, how they’re calculated and more

Summary

Three letters – APR – can help you understand the ABCs of borrowing money with a credit card or another financial product. Follow along as we educate you about all things APR.

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Three letters – APR – can help you understand the ABCs of borrowing money with a credit card or another financial product. Follow along as we educate you about all things APR.

What is APR?

APR stands for annual percentage rate. It refers to the annual cost of borrowing money, either with a credit card or a loan (such as a mortgage, auto loan, student loan or personal loan).

The interest rate is the basic amount, shown as a percentage, that a lender charges you to borrow money. APR takes into account the interest rate along with any fees being charged (except with credit cards), and it’s also shown as a percentage.

For instance, a credit card might carry an APR of 17.5 percent, while a mortgage might offer an APR of 3.75 percent.

See related:  What is the average credit card APR?

What kinds of products have APRs?

Credit cards and various types of loans, like mortgages, auto loans, student loans and personal loans, come with APRs.

For credit cards, the APR is what you’ll wind up paying if you don’t pay off your monthly balance and you carry over the debt to the next month. A credit card APR does not include fees and other costs.

On the other hand, the APR for mortgages, auto loans, student loans, personal loans and other lending products does include fees and additional costs.

Typically, APRs for credit cards and other lending products fluctuate from lender to lender and from borrower to borrower, based on your credit score and other factors. The better your credit score, the more likely it is that you’ll receive a lower APR, which can translate into paying less to borrow money.

How are APRs calculated?

Fortunately, the math involved in calculating APR isn’t as complicated as you might think.

First, let’s look at how a credit card issuer calculates APR.

For a credit card, the calculation starts with an index. A popular index to use is the U.S. prime rate (or prime lending rate). This rate is 3 percentage points above the federal funds rate set by the Federal Reserve, which establishes U.S. monetary policy.

The federal funds rate is the interest rate that banks and other institutions that hold deposits charge each other to lend money on an overnight basis.

A credit card issuer then tacks on a margin, which is the number of percentage points added to the prime rate or another type of index. The margin is typically tied to your credit score. A higher credit score usually results in a lower margin.

So, let’s say the index – in this case, the prime rate – is 3.25 percent. If the card issuer assigns you a margin of 15 percentage points, then the credit card’s APR would be 18.25 percent. If you’ve got a card with a variable rate, a change in the index can send the APR up or down.

Now, let’s look at the APR for mortgages, auto loans and other loans.

In this equation, a lender sets the APR by looking at the interest rate and loan repayment term (such as 30 years); for mortgages, the APR also includes closing costs.

So, let’s say you take out a $275,000 mortgage with a 4.25 percent interest rate for a loan term of 30 years, and your closing costs are $6,300. In this case, your APR would be 4.44 percent.

See related:  How do credit cards work?

What types of APR are there?

Among all lending products, credit cards have the most kinds of APR. Meanwhile, loans typically come with just one sort of APR (although a homebuyer can get a mortgage with what’s known as an adjustable rate). Here are the types of APR you’ll come across with a credit card.

Purchase APR

The purchase APR is the rate you pay when you make purchases with your credit card. It’s typically the lowest of the credit card APRs.

Cash advance APR

If you borrow cash with your credit card, you’ll pay the cash advance rate. It’s often higher than the purchase APR.

Penalty APR

A card issuer hits you with a penalty APR when you’ve failed to follow the lender’s terms and conditions. For instance, card issuers frequently charge a penalty APR when you make a payment after the due date. The penalty APR usually is higher than the purchase APR or cash advance APR.

Introductory (or promotional) APR

A card issuer frequently will offer an introductory or promotional APR for special purchases as well as balance transfers or cash advances.

For example, an issuer might dangle a 0 percent APR for a new card if you transfer a balance from another card and pay off the transferred balance within, say, 12 months. If you fail to wipe out the balance within the allotted time, interest charges will kick in.

See related:  Picking the right credit card

What’s the difference between a fixed-rate APR and a variable-rate APR?

Remember that index we explained earlier? The index affects whether a credit card has a fixed rate or a variable rate.

A fixed-rate APR does not change when the index changes.

“This does not mean that the interest rate will never change, but the issuer generally must notify you before the change occurs, and in most circumstances can apply the higher rate only to purchases and other transactions you make after you get the notice,” according to the Consumer Financial Protection Bureau.

However, a variable-rate APR does change when the index changes. The cardholder agreement for your card explains how the APR can go up or down over time.

How do I know whether an APR is good or bad?

A good APR is one that’s below the average APR. Keep in mind, though, that only those people with excellent credit qualify for below-average APRs.

An above-average APR isn’t necessarily bad. But the higher an APR is, the more you’ll pay for purchases, cash advances and other credit card transactions — unless you pay off your balance in full every month, thus avoiding interest charges.

Editorial Disclaimer

The editorial content on this page is based solely on the objective assessment of our writers and is not driven by advertising dollars. It has not been provided or commissioned by the credit card issuers. However, we may receive compensation when you click on links to products from our partners.

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Credit Card Rate Report Updated: July 29th, 2020
Business
13.91%
Airline
15.48%
Cash Back
16.09%
Reward
15.82%
Student
16.12%

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