When you start to look into credit cards, you will see one term cropping up again and again: APR.
But what exactly is an APR and how could it affect your borrowing? The key things to know when looking at APRs are how it’s applied and how it’s calculated. Let’s break this down.
What is APR?
APR stands for annual percentage rate, and is basically the cost of borrowing over the year. All lenders use it in order to standardise their offers and make it easier for borrowers to compare them.
But what is an APR actually made up of? An APR takes into account the interest as well as any other charges you’d have to pay, such as an annual fee. This is why you sometimes see an APR that is different from the card’s purchase rate (the interest charged on purchases). For example, if you spend £1,200 at an annual interest rate of 22.9% with a £140 annual fee, your representative APR will be 57.6%. This helps you to compare the real cost of using this card.
In case you’re attempting to work out how to get from the interest rate to the representative APR, it’s not quite as simple as it may seem at first thought. Regulators require that a specific, iterative calculation be run to determine the representative APR — a calculation that’s best done with a spreadsheet program (and a large mug of tea). If you’re the hardy type, there is plenty of in-the-weeds information about the APR calculation on the FCA’s website. However, for our purposes, the important thing to bear in mind is that the representative APR is a standardised calculation that helps make the total payment more comparable from one card to the next.
Representative vs personal?
If you are looking at a card’s APR, you will typically see ‘representative’ tacked on the end. This basically means the card’s headline rate, so the rate that 51% of applicants will be given. Lenders will assess what APR to give you based on your personal circumstances. If you are among the 49% who do not achieve the representative APR, then you will be offered a personal APR, which will most likely be higher than the advertised rate.
Here is where it all gets a little bit complicated – but bear with me, it will all make sense soon. Let’s look at the nitty gritty of compounded interest.
Say you have an APR of 12% (for mathematical ease). The amount of interest you are charged is not just 12% of your balance each month. Instead your compound interest is calculated to include the interest you pay on interest as well as on your outstanding balance.
For example, imagine you have a balance of £1,000 on your card and you do not pay anything off in the 12 months you have a card. With an APR of 12% your monthly rate will stand at 1%, so the interest you will be charged in your first monthly statement will be £10. But next month, your balance will have increased to £1,010 because of the previous month’s interest charge, so now the interest you will have to pay on your balance of £1,010 will be £10.10, taking your balance up to £1,020.10, and so on, and so on. So if you were to pay nothing for the whole year, you would end up paying a total of £126.83 in interest – not just 12% of £1,000, which is £120.
This is where you can find yourself in a difficult situation, as if you don’t get to grips with what compounded interest really means it is all too easy to end up in a spiral of credit card debt. As Albert Einstein (supposedly) once said ‘compounded interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it’.
That said, most cards have a ‘grace’ period on purchases, meaning you will not be charged interest on purchases if you pay your balance in full at the end of the month. If you can manage to do this, your APR will have no impact on your cost of borrowing.
As you might imagine, whether your card provider compounds interest, and over what time frame — daily compounding, for example, would lead to higher overall charges than monthly — is important to understand. As is the length of that grace period on purchases, if there is one offered. So be sure to take a good read through the terms of your credit card agreements.
Power to the borrower
The main advantage of understanding your APR is that you can then be in control of your finances. If you understand how your interest is calculated and what rate you have, then you can avoid being caught out by interest charges and rising debt. Being informed means having power. Understanding what your APR is can put you in the driving seat of your borrowing.
One final thing to take note of: APR does not take into account the balance transfer rate or money transfer rate, or any additional charges you may incur for late or missed payments. It is purely calculated from the purchase rate and annual fees. It is best to look at your card’s summary information to find out the rates of these elements.
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