Understanding APR

When it comes to debt and credit, understanding how the annual percentage rates (APR) and monthly interest rates apply to your debts is critical for successful money management. Without the right understanding of how APR works and how various types of interest rates can be applied to your debts, you can easily get into trouble when your bill comes due. On the other hand, having a firm grasp of how interest rates work can help improve your finances dramatically.

If you have questions about interest rates and how they apply to your debts, or you need help learning how to manage your debt successfully, call us at  to speak with a certified credit counselor. Your credit counselor can answer any questions you have, assess your budget, and provide advice on how to manage your debt successfully with a free consultation.

 

Interest rates versus APR

People often wonder if interest rates and APR are the same thing. In truth, they are actually two different types of values—particularly when it comes to your mortgage. An “interest rate” usually refers to the basic monthly interest that’s applied to your debt. The “annual percentage rate” (APR) refers to the yearly interest plus any account maintenance or yearly fees that apply to your account. In this light, APR gives you a better idea of what you’ll be expected to pay per year, while the interest rate allows you to calculate the monthly payments on your debt.

 

Calculating monthly payments using interest rates and APR

You can determine your monthly interest rate by dividing your APR by twelve. Your minimum payments on revolving debts are typically calculated using one of two formulas:

  1. Monthly payment = monthly interest + 1% of balance
  2. Monthly payment = % of balance owed (usually 2%-5%)

This is why minimum monthly payments on revolving debts like your credit cards go down as you pay off the bill. You can usually find the payment formula on your monthly statement.

The following shows an example of how each of these formulas would be used:

  • I have a credit card with 18% APR and I spend $5000 on the card
  • If the monthly payments are calculated using a percentage of the balance:
    • $5000 x 2% interest = $100 payment
  • If the monthly payments are calculated as 1% of your balance plus monthly interest:
    • 18% APR / 12 months = 1.5% monthly interest rate
    • ($5000 x 1%) + ($5000 x 1.5%) = $125 payment

When you consider the interest accrued during this month is $75, you can easily see how most of your payment is only covering interest. You’re paying only $25 or $50 to the principal debt respectively. This is why it takes so long to pay off debt if you’re just paying the minimum payments requested each month.

 

Take note of APR type

Another vital element in understanding APR is to know the various types of APR that can be applied to your debts. This is particularly important for credit cards, as they often have several different APR values that can be applied—depending on what you want to do with your line of credit and how you pay your bills. It’s essential to know when these different APR values will be applied, so you won’t be surprised when your bill arrives.

The following are the most common types of APR you see associated with your credit cards:

  • APR for Purchases: This is the standard APR applied to your account for normal transactions. If you are current with your payments and making regular purchases in a store or online, this is the APR that will be applied to your bill. This is also the interest rate you are shown and approved for when you apply for a new line of credit.
  • APR for Balance Transfers: If you are doing a balance transfer to consolidate multiple credit card debts to a single low-interest credit card, many creditors apply what’s known as a balance transfer APR interest rate. This rate is almost always higher than purchase APR, so it’s important to understand if your account has a balance transfer APR if you’re considering a balance transfer as a way to manage your debt. A balance transfer fee may also be applied in addition to the balance transfer APR.
  • APR for Cash Advances: Some credit cards allow you to take out a cash advance on your credit card, instead of applying for a payday loan. However, they often apply a cash advance APR. Your creditor may also apply additional cash advance fees as well.
  • Penalty APR: This interest rate is applied to your account when you are late with a payment or miss a payment on your debt, or when you go over your credit limit. Creditors will generally apply penalty APR to your next month’s bill and for up to 6 months after the penalty was incurred.