If you’re applying for your first credit card, you might not understand the language that financial institutions use to describe fees and charges. For example, do you know the difference between a credit card APR and credit card interest rates?
If not, you’re not alone. It’s common for people to misunderstand these terms, but knowing what they mean is essential if you want to take control of your finances.
With that in mind, we’d like to explain APR versus interest rate. What do these things mean and why should they matter to you?
What is APR?
Let’s start with some definitions. The APR is the Annual Percentage Rate. It’s meant to reflect the total amount it will cost you to borrow money per year on a percentage basis.
Where this gets confusing is that the term APR is used for all kinds of financial arrangements, including both mortgages and credit cards. However, it means different things in different places.
For example, a mortgage might have an interest rate of 6%, but the APR includes fees to be charged as well. In that case, the APR might be 6.15% because it includes the fees.
However, with credit cards the APR is just the interest. Fees are not included because it’s not possible for credit card issuers to predict which customers will be charged which fees during a year.
One customer might have several late fees and finance charges that wouldn’t apply to someone who paid their balance in full each month.
It may be worth noting here that most credit card issuers start by using the prime rate and then adding their interest to it, making it a variable rate. If your card has an APR of 16% and the prime rate is 4.5%, the card issuer added interest of 11.5% to the prime rate.
What is Interest?
Interest is the amount you pay for the privilege of borrowing money. You can expect to pay interest for both long-term loans like mortgages, as well as for short-term lending like credit card purchases.
There are many things that factor into deciding the interest rate on a credit card. Here are some of them:
- The cost to the lender of not being able to use the money being loaned out
- The cost of inflation
- The risk that the borrower may not repay the loan
It stands to reason, then, that people with excellent credit are likely to be rewarded with lower interest rates than those with poor credit or no credit. The financial institution knows they can rely on the borrower to pay their credit card balance, and so they are willing to lower the rates in return.
The interest on credit cards is almost always expressed as an annual rate. However, that can be misleading because nearly all financial institutions compound interest daily.
Here’s what that means. If you have an annual interest rate of 16%, you can calculate your daily rate by dividing that by 365. Your daily rate would then be approximately 0.043%.
If you had a balance of $1,000 on the first day of the year and made no payments, the daily interest would be calculated and added to your balance. Then, the next day the interest would be calculated from the new amount, and so on. This is known as compounding the interest. Even though this might be a good example of how compounding interest is calculated, it goes without saying that making no payments for a year isn't something we'd recommend!
In other words, if you carried that balance for the entire year, you would pay more than 16% interest because the balance would constantly be increasing thanks to compounding.
The Difference Between APR and Interest
While in some situations there is a difference between APR and interest, when we talk about these terms as they relate to credit cards, they are the same.
The key difference – when there is one – is that the APR may include fees that are not, strictly, interest. That’s true of mortgages but not of credit cards.
To put it another way, when you’re comparing credit cards, you should take the APR and add any fees that you may have to pay to it to get a clear idea of what it might cost you to have the credit card. If a company charges you a $50 annual fee, that amount is not included in the APR and must be considered separately.
Keep in mind that if you pay your balance in its entirety every month, you will not pay interest on your credit card. People sometimes put off applying for a credit card because of the interest, but the cardholder has some ability to control how much interest they pay based on how they manage their card.
When you’re comparing credit cards, you can use the terms APR and interest interchangeably. The key thing to remember is that fees are not included in the APR. You must add them to get a clear idea of how much a credit card costs.
If you have any other questions, contact your local branch to get in touch with one of our knowledgeable team members.
Posted on Dec 26, 2017
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