Originally Posted On: https://www.iquanti.com/
Why does your credit card bill always seem to be higher than expected? Did that last payment bring the balance down at all? These are common questions asked by consumers who carry credit card debt. Many of those questions can be answered by understanding APR vs interest rate. These two concepts are not the same, causing some confusion. Let’s examine both and how they affect your credit card balance each month.
Most Credit Card Companies Charge Variable Interest Rates
If you apply for a personal loan or mortgage, you’ll likely get a fixed interest rate. Fixed interest rates are set at the beginning of a loan agreement and never change while you’re paying off the balance. Credit card companies don’t work like that. Most of them charge a variable interest rate based on the prime rate for that particular month.
This is one factor causing your credit card bill to increase. The Federal Reserve Bank (Fed) is responsible for setting what is known as the “Federal Funds Rate.” It’s the interest rate that banks charge when they borrow money from one another. That rate is used to set the “prime rate,” which is the best rate consumers are charged on loans and credit cards.
Using the prime rate, credit card companies determine how much interest they’ll charge during the billing period. When the fed rate goes up, the prime rate is higher, and you pay more money for those outstanding credit card balances. Believe it or not, that’s the simple part of calculating your monthly payment. As they say in the movies, “Wait, there’s more.”
Your Interest Rate is Only Part of Your APR Calculation
Here’s where the confusion lies. The annual percentage rate (APR) financing charges aren’t just your interest rate, which is variable. Your APR is a calculation of the annual cost of transactions, including fees and interest. That means that the APR will be higher than the interest rate. You’re not paying 28% in interest. You’re paying 28% in the total costs for the credit card company.
The APR does not account for compounding, but your interest rate does. Monthly interest is charged on your balance after you make a payment. In the next billing period, you’re charged interest on the sum of your outstanding balance plus the interest added from the previous month. Can you see now how those bills are going up so fast?
Avoiding Interest and APR by Paying Your Full Balance
The best way to avoid interest and APR is to pay your monthly balance in full every month. The philosophy about “keeping a low balance” on credit cards is a fallacy that will just cost you extra money. All charges from your credit card company, except for monthly and annual service fees, are based on a percentage of your balance. 28% of a zero balance equals zero.
Credit card companies are required to disclose their APR so you can compare them with their competitors. Be vigilant when you do this because the terms “APR” and “interest rate” are often used interchangeably in the advertising and web content for these companies. Read the fine print carefully and plan on paying your entire balance monthly if you can.