What is APR and how is it calculated?
By Benjamin Salisbury
Whether you just activated your first credit card or have been swiping for years, it is important to understand (or brush up on) your card's interest rate. APR is a term you hear often, but you may not fully understand how it's calculated, how it's applied or how it impacts your credit card payments.
APR stands for annual percentage rate. It's the card's interest rate, plus other fees, expressed in a standardized, annualized way. The rate is applied each month that an outstanding balance is present.
"The APR takes into account not just the interest on the loan, but also other charges you have to pay, for example, any arrangement fee," a Financial Conduct Authority (FCA) spokesman said in an emailed response to questions.
In other words, your interest rate may be 12%, but if there are other fees that amount to 3%, your agreement will show that the APR is 15%.
"All lenders have to tell you what their APR is before you sign an agreement. It will vary from lender to lender," says the FCA spokesman.
The APR helps you understand the actual cost of borrowing on a credit card and allows you to compare different products. "The APR is meant to be a standardised way of showing the total cost of borrowing over a year so you can not only compare different credit cards but also different products such as taking out a credit card vs. the cost of taking out a loan," a spokesman from consumer group Which? said in an emailed response to questions.
How is APR calculated?
Let's look at a simple example: if the APR is 12% and you borrow £1,000 in January and don't repay it until the end of the year, using a simple interest calculation (meaning, interest is only charged on the initial £1,000 principal), £120 would be the cost of borrowing for the year.
This is a basic way of roughly understanding the cost of APR. However, it's not really correct because most credit cards and loans charge compound interest. Compound interest is the interest calculated on both the initial principal and on the accumulated interest of previous periods on the loan. It's often thought of as "interest on interest," and it makes your loan balance grow at a faster rate than simple interest.
An example: say you don't make any payments to your credit card bill, or only make the minimum payment and leave a balance. The amount you still owe will gain interest the first month. When the next month's bill is due, if you again miss the payment or don't pay it in full, you now owe the initial balance plus the interest applied to last month. And that total will -- you guessed it -- be charged more interest. This is compounding interest.
Going back to our original example, if you borrowed £1,000 at 12% APR over 10 years without making any repayments, by the end of the 10-year term, you would owe more than £3,100. (Any number of online compound interest calculators can help you figure out how much you will pay on your own debt).
That's why it's so important to pay off as much of your balance as you can each month. Even if you can't pay the full balance, you should still aim to pay more than the minimum so that the interest and fees are applied to a smaller sum.
Common APR confusion
It can be confusing when rates change. A credit card company may increase your interest rate but may present this in monthly terms, which makes it sound very small, when, in fact, it's quite a jump.
The APR only includes mandatory charges, so extra charges, such as payment protection insurance, are not included in it. You should always ask if there are other costs not included in the APR when comparing cards.
Finally, the lender may not approve you for the advertised APR rate. For instance, if you see a deal that advertises a very low APR, but notice that you are approved for a much higher one, it's likely not a mistake. The best rates only apply to about 51% of applicants -- those with the best credit scores and ratings, and who are deemed the lowest risk.See related: Understanding and avoiding credit card fees, Skip the fine print, skip vital information
Published: 23 January 2015
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