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Understanding how a credit card works might be difficult enough, but it gets a little harder when you start throwing in two confusing, interchangeable, and slightly similar terms in to the mix: interest rates and annual percentage rates (APR). If you don’t clearly understand the difference between an APR and an interest rate, then you may not actually understand the true cost of a credit card.
APR vs. Interest Rate
Simply put, the interest rate on a credit card is the cost paid on a credit card balance in a year. It could be a fixed rate or a variable rate, but it is always expressed as a percentage. Despite being expressed as an annual rate, Interest is commonly paid on a monthly basis, so you only pay a portion of your annual interest on credit balances that roll over into a new billing cycle.
APR is also expressed as a percentage, but it incorporates all other costs associated with administering a credit card in addition to the interest cost. The APR is almost always going to be higher than the interest rate.
Both APR and interest rate expenses are calculated in the same way; both can actually be calculated on a daily basis. Remember that both APRs and interest rates are annual. In order to calculate the expected daily cost of APR or interest, you take your balance, multiply it by your APR or interest rate, divide by 365, and multiply it by the number of days in your billing cycle. Since these two rates are different, they typically won’t give the same return value; APR will normally be higher since it includes other charges.
Comparing Apples to Apples
The confusing part is when consumers want to compare one credit card to another. It’s possible for a credit card to have a lower interest rate and a lower monthly payment than one card, but it could have a higher APR. So, it’s possible to pay less interest each month, but you could end up spending more in APR.
Luckily, many credit card offers today advertise the APR as opposed to the interest rate, making it much easier to compare credit cards. As a simply rule of thumb, lower APR generally indicates lower cost for a credit card holder so long as they are up-to-date on their payments.
Why is this such a big deal? The importance of the APR in comparing costs was codified in the Federal Truth in Lending Act which requires that every consumer credit card agreement include information on both the APR and the interest rate. It also requires all lenders to follow the same guidelines for coming up with an accurate APR. In essence, the Federal Truth in Lending Act ensured that the APR can enable consumers to quickly compare the true costs between one card and another.
Author: Jeff Gitlen
Jeff Gitlen writes about a wide range of finance topics including everything from student loans to credit cards to small business financing. Jeff's work has been featured on a number of sites including Bloomberg, CNBC, Forbes, Market Watch, and more.