Annual Percentage Rates (APRs) Explained in 60 Seconds
A credit card is essentially a tool for borrowing money. That cardholder (you) are the borrower. The issuer (Capital One, Discover, for example) is the lender.
Let’s take a look at a typical credit card transaction.
You walk into your electronics store. You recently got a salary increase and are feeling good, so you decide to grab the newest 50″ TV. The TV costs $250.
When it comes time to pay, you pull your credit card out of your wallet and hand it to the clerk. The clerk swipes your card, you sign the receipt and are on your way.
But What Just Happened Behind The Scenes?
When you bought the TV, the credit card issuer paid the electronics store on your behalf and will follow up with a bill later that month.
In essence, you borrowed money from the credit card issuer to buy the TV. The issuer will give you a little bit of time, referred to as the grace period, to pay the money back.
If you don’t pay the money back by the end of the grace period, then you are “carrying a balance,” and the issuer will start charging you interest on that balance. The interest rate charged is the cost of borrowing money from the issuer.
How does the issuer determine the amount of interest it charges?
The issuer bases the dollar amount of interest on the Annual Percentage Rate, or APR. The APR reflects your credit history and the Prime Rate, which fluctuates with current market conditions.
Getting back to our TV example, let’s say your APR matches the national average of 18%.
You decide not to pay back your $250 by the end of the grace period. Instead, you only pay the minimum amount due of $5.
The APR and interest charge starts working against you if you don’t pay back the borrowed amount by the end of the grace period. Going forward, the issuer will charge you 0.05% interest on the $245 every day you carry the balance.
How did we arrive at those numbers?
The 0.05% daily interest rate is equal to 18% divided by 365 days. Some credit cards calculate the daily interest rate using the 360 days, but for this analysis, it doesn’t make much of a difference.
The $245 is equal to the $250 you paid for your TV minus the $5 minimum payment you made.
Now let’s assume that you don’t buy anything else the following month (30 days) and decide only to make the $5 minimum payment once again. That $5 will mostly go to paying the $3.62 interest charge, with the remainder paying down the $245 balance.
Here’s where you can run into trouble. All those minimum payments go towards paying your interest charges not to pay back the money you borrowed to buy the TV. You can end up paying a lot more for that TV than you initially bargained for!