If you’re carrying a balance on a credit card rather than paying it off in full every month, it’s important to know the interest rate you’ll be charged. When you look at the Schumer box for your card — the federally required disclosure of rates and fees — the first item listed is the “Annual Percentage Rate (APR).” That’s your interest rate.
With some financial products, the interest rate and the APR are different. With credit cards, though, they’re one and the same. No difference.
The federal Truth in Lending Act, which governs all consumer lending contracts, requires lenders to state their interest rates as APRs. The APR is the “real” annual cost of borrowing money, including not just interest but also fees and other charges. When you take out a mortgage, for example, you often have to pay an origination fee, points and other charges upfront. The APR takes those into account, so a mortgage with an interest rate of, say, 6% might actually cost you something like 6.15% a year.
With credit cards, though, the APR is just interest. You may have an annual fee or incur charges for balance transfers, cash advances, late payments and so on, but credit card issuers don’t include those in the APR. That’s because it’s impossible to predict which cardholders will incur which fees.
How is the interest rate set?
The interest rate on credit cards is based on the prime rate. That’s the interest rate banks charge their most creditworthy clients, and it’s usually 3 percentage points higher than the federal funds rate, set by the Federal Reserve.
Credit card issuers typically charge an APR of the prime rate plus a variable percentage rate. For example, if your APR is 15.5% and the prime rate is 4%, the issuer has added 11.5 percentage points of interest. This calculation is listed below the Schumer box on your terms and conditions sheet.
Many cards charge different customers different rates based on their creditworthiness. The Schumer box may state that the APR is, say, 11.5% to 22.5%. In that case, cardholders with sparkling credit will pay 11.5%, while those with worse credit will pay a rate on the 22.5% end of the range.
How issuers calculate interest
Most credit card issuers use the average daily balance when they calculate interest.
Here’s how it works: Your credit card issuer adds up the daily balances on your credit card for the month and divides that by the number of days in the billing cycle. That’s your average daily balance.
To determine the finance charge, it multiplies the average daily balance by the APR and the number of days in the billing cycle. It divides that by 365 to get the daily rate. For example:
Average daily balance = $200
APR = 12% or 0.12
Billing cycle = 25 days
Number of days in the year = 365
$200 x 0.12 x 25 / 365 = $1.64 finance charge
This doesn’t seem like much, but if you owe thousands of dollars, the finance charge will be much higher, and your minimum payment will rise, too.
When an APR doesn’t matter
Cardholders who don’t carry a balance on their credit cards don’t have to care about the APR because it never affects them. Most probably don’t even know what their rate is. If you pay your balance in full each month by the due date, you won’t be charged interest. That’s the best way to use credit cards.