Credit Interest Rates

Understanding credit card APRs & interest rates

The average credit card annual percentage rate (APR) in the US is currently 17.73%. However, unlike personal loans, where the APR includes the loan interest and all fees, for credit cards, the APR only represents the credit card interest rate per year.

Existing regulations require companies to disclose credit card pricing in the form of an APR, which is the yearly interest rate of the card. This rate is the same as the periodic rate, which is what credit card companies use to calculate and charge interest on a daily, monthly, or quarterly basis.

In simple terms, the periodic rate is the APR expressed over a duration shorter than one year.

To calculate the periodic rate, divide the APR by the number of billing periods in a year:

  • A daily periodic rate (DPR) is the APR divided by the 365 days in a year (so, a 12% APR translates to an approximately 0.033% daily periodic rate).
  • A monthly periodic rate is the APR divided by the twelve months in a year (a 12% APR translates to a 1% monthly periodic rate).
  • A quarterly periodic rate is the APR divided by the four quarters in the year (a 12% APR translates to a 3% quarterly periodic rate).

On your credit card billing statement, you’ll see the specific periodic rate used to calculate your finance charges (the fee on your credit card).

Credit card issuers will sometimes offer one APR for all approved credit card users, but most provide a range. You’ll get a specific APR within this range based on multiple factors, including the prevailing prime lending rate, the APR type, and your creditworthiness, among others listed below.

The calculation of a credit card APR starts with an index, which, in the US, is the prime rate (also called prime lending rate). This rate is 3% above the Federal Reserve’s federal funds rate (the interest rate banks and institutions use when lending money overnight to each other).

Creditworthiness

Credit card companies also use your credit report and credit score to evaluate your credit history and risk level to determine the APR. A high credit score can mean lower interest rates, and a low score can mean higher interest rates. This concept is called risk-based pricing.

The credit card issuer uses this risk-based pricing to tack on a margin to the prime rate. For example, based on your credit history, the card issuer may assign you a margin of 15% in addition to the 3.25% prime rate, so your credit card APR would be 18.25%.

Issuers can attach multiple APRs to a single credit card that can apply to either purchases, balance transfers, or cash advances. Also, cards may have APRs that change after six months or one year, and the credit card may have either a variable or fixed APR.

Card companies can also entice consumers with 0% interest offers that last for a year, or longer, and then, after the promotional period ends, the rates will increase.

If you fall behind on payments, or default, card companies can increase your APR. On the other hand, you can negotiate for a lower APR if you’re a long-term and loyal client who pays card balances on time. Take note that credit cards with rewards, such as cards offering points or cash-back offers, generally have higher interest rates.

APR and Credit Card Balance Calculation Methods

Different credit card companies use different balance calculation methods when applying the APR, and these specific methods can influence your credit card finance charges. Such balance calculation  methods include:

  1. Daily balance method
  2. Previous balance method
  3. Adjusted balance method
  4. Average daily balance method
  5. Ending balance method

What is the Daily Balance Method?

With the daily balance method, issuers calculate your finance charge using the actual balance on each day of your credit card billing cycle—not an average of your balance during the billing cycle.

In this case, the finance charge is the sum of each day’s balance multiplied by the daily periodic rate (1/365th of your APR).

For example:

Tom has a credit card with a 14% APR, and he maintains a balance of $1,000 on each day of the card’s 30-day billing cycle. Here’s his finance charge:

Daily rate = 1/365 x 14% = .0385%

Finance charge = (day 1 balance x daily rate) + (day 2 balance x daily rate) + … + (day 30 balance x daily rate)

= ($1,000 x .000385) + ($1,000 x .000385) + … + ($1,000 x .00385)

= $11.55

What is the Average Daily Balance Method?

With the average daily balance method, issuers total each day’s balance within the billing cycle and divide the sum by the number of days in the billing cycle. This produces the average daily balance, which card issuers multiply by the monthly periodic rate (APR divided by 12 months) to give your finance charge.

One benefit of this method is that credit card issuers credit your account from the day they receive a payment. To assess the balance due daily, issuers sum the day’s beginning balance and subtract any payments and credits you make to your account that day. Therefore, the total balance due daily can fluctuate from one day to the next.

Issuers usually include cash advances in average daily balances. To illustrate this, here is an example:

Jane has a credit card with a 1.5% monthly interest rate, and her previous balance is $500. On the 15th day of the billing cycle, her credit card company receives and credits her payment of $300. On the 18th day, she makes a $100 purchase. Here is her average daily balance and finance charge:

Average daily balance = ((14 days x $500) + (16 days x $200)) / 30 = ($7,000 + $3,200) / 30 = $340.

Finance charge = 1.5% x $340 = $5.1

If you make bigger payments and make such payments earlier in the billing cycle, you can generally get a lower finance charge with this method.

What is the Previous Balance Method?

With the previous balance method, credit card issuers charge interest based on the amount you owe at the end of the beginning of the billing cycle (the debt you carry over from a previous billing cycle to a new one).

Issuers multiply the monthly period rate with your previous balance to calculate the finance charge for the current billing cycle. This method can be more costly if you’re trying to pay down debt because payments don’t immediately reduce your finance charge. Since balances carry over to the next billing cycle, activity this month affects the next month’s finance charges.

This method does have an advantage because charges to your account during the billing cycle won’t produce a higher finance charge. You can minimize the finance charges each month by paying more than what you charge every month.

What is the Adjusted Balance Method?

With the adjusted balance method, issuers base finance charges on your debt at the end of a billing cycle, after posting payments and credits. This is different from the ending balance method since it incorporates a grace period that allows purchases made and paid for within the current billing cycle not to be figured into the current adjusted balance.

You can receive significantly lower finance charges with the adjusted balance method compared to other methods, such as the previous balance and average daily balance methods. But card issuers use the adjusted balance method less frequently than the average daily balance method and previous balance method, which are the most commonly used ones.

What is the Ending Balance Method?

With the ending balance method, issuers simply use your balance at the end of the billing cycle (the balance at the beginning of the billing cycle plus charges made during the billing cycle—minus payments during the billing cycle).

One more method that card issuers used in the past is the double billing cycle method, which was outlawed by the Credit CARD Act of 2009. This method used the average daily balance of both previous and current billing cycles, which was the most expensive method of calculating finance charges.

The Difference Between a Fixed-Rate APR and a Variable-Rate APR

The index (the prime lending rate) used by card issuers to determine credit card APR can also determine a fixed or variable rate APR.

A fixed-rate APR won’t change when the index changes. While it’s not entirely true that the interest rate will never change, issuers must generally notify credit card holders before the change occurs. In most cases, issuers can only apply higher rates to purchases and other transactions made after you receive the notice.

A variable APR changes when the index changes. The cardholder agreement explains how the APR can change over time.

APR Grace Period

Card companies can give you a “grace period” that allows you to pay off your balances without interest charges—as long as you pay off your balances by the due date. Many cards offer a grace period between the end of a billing cycle and when the bill is due, which is usually about 25 days.

Due to the grace period, you can avoid interest charges altogether by always paying off your balances at the end of every billing cycle.

The law doesn’t require credit card companies to give grace periods, but most do provide them, and the card companies must also deliver bills to you at least 21 days before payment is due.

Grace periods typically only apply to purchases on your credit card. If you get a cash advance or use a check from your card issuer, you’ll usually start paying interest from the transaction date.

Different Types of Credit Card APRs

Up to five different APRs apply to different actions on your credit card. Whether credit card issuers apply none, one, some, or all APRs depends on if you’re paying your balance in full during the grace period, making new purchases, transferring balances, missing payments, or getting a cash advance.

Introductory (or Promotional) APR

Card issuers frequently offer introductory/ promotional APRs for special purchases, balance transfers, or cash advances.

For example, the card issuer might offer a 0% APR for new cards if you transfer your balance from another card and pay it off within a period, such as 12 months. If you don’t pay off the balance within that time, the normal credit card APR starts to apply.

Purchase APR

This APR applies to all purchases made with your credit card. This is the most common APR, which people tend to consider first when evaluating credit cards.

Balance Transfer APR

This APR applies to your old balance if you move or transfer it onto a new credit card. In certain instances, the balance transfer APR can be greater than the purchase APR.

Penalty APR

If you become delinquent in your credit card payments (you don’t pay the minimum required amount for 60+ days), a penalty APR applies. Issuers apply the rate to all balances on your account, and it’s significantly higher than other interest rates.

29.9% is the typical penalty APR (existing regulations restrict banks from charging an interest rate higher than this). Some credit cards have lower penalty APRs, such as federally chartered credit union cards, which have APRs capped at 18%. Other cards don’t have any penalty APR.

The issuer will send you a written notice 45 days before the rate increase, based on the terms set out by the Credit CARD Act of 2009. Fortunately, penalty APRs for consumer credit cards aren’t permanent.

The card issuer will review your account at least once every six months to consider lowering your APR. If you make on-time payments, you may get your old APR back or a reduction. Continuing to miss payments could mean the penalty APR remains.

Cash Advance APR

Credit card companies will charge a cash advance APR if you use your card to withdraw funds, such as through an ATM. While usually greater than purchase and balance transfer APRs, cash advance APRs are usually not as high as penalty APRs.

Cash advance APRs don’t have a grace period, so issuers start charging it the day you take out a cash advance.

Where to Find Your Credit Card’s APR

The “Schumer box” provides the necessary information about interest rates and fees associated with your credit card. This is a simple, standardized display with all the details about the rates and fees  of your credit card. It was created through legislation spearheaded by U.S. Senator Chuck Schumer.

When comparing cards, you can find the Schumer box through the credit card’s landing page by clicking on a link with such words as “rates and fees” or “pricing and terms.”

The Credit CARD Act expanded the Schumer box concept in 2009, adding a requirement that card companies provide clear information on all card statements, including:

  • How much you’ll pay in interest
  • Fees if you opt to pay only the minimum monthly payment

These requirements complement various other restrictions on billing, fees, and more.

Conclusion

Since APR makes up a significant portion of your credit card cost, you need to understand how it applies to your specific card. Knowing the type of APR and the finance charge calculation method can help you gauge the cost-benefit ratio of having a credit card.

Note that other fees may apply to your credit card, which you should account for when evaluating the overall cost of this financing option. You can also contact CreditNinja’s customer care team for inquiries about other financing options.

References:

https://www.ftc.gov/sites/default/files/documents/statutes/credit-card-accountability-responsibility-and-disclosure-act-2009-credit-card-act/credit-card-pub-l-111-24_0.pdf
https://www.federalreserve.gov/bcreg20090421a3.pdf
https://www.experian.com/blogs/ask-experian/what-is-apr/
https://creditcards.usnews.com/articles/what-to-do-if-you-trigger-a-penalty-apr-on-your-credit-card
https://creditcards.usnews.com/articles/average-apr
https://www.consumerfinance.gov/ask-cfpb/what-is-a-grace-period-for-a-credit-card-en-47/
https://www.cnbc.com/select/what-is-a-grace-period/
https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-fixed-apr-and-a-variable-apr-en-45/
https://www.federalreserve.gov/consumerinfo/wyntk/wyntk_ccrules.pdf
https://www.fdic.gov/regulations/laws/rules/6500-3450.html
https://www.investopedia.com/terms/a/averagedailybalance.asp
https://www.debt.org/credit/cards/interest/
https://www.thebalance.com/understanding-periodic-rate-960705
https://www.cnbc.com/2019/05/17/55-percent-of-americans-have-credit-card-debt.html