What is APR?

Understanding how interest rates apply to credit cards.

Calculator on paper with interest rates

If you feel like you can’t make headway in paying off credit card balances, APR may be at least partially to blame. Credit cards have relatively high APR, which creates challenges as you work to eliminate your debt. Understanding how credit card APR works and what you can do to keep interest charges minimized is critical. This guide can help.

What is APR and how does it apply to credit cards?

APR stands for annual percentage rate. It represents the interest applied to a debt over a one-year period. For credit cards, the annual percentage rate is equal to the annual interest rate. For some loans, there are other fees included in APR.

APR determines the cost of using a particular type of credit. A high APR means higher costs for a consumer.

Credit cards have relatively high annual percentage rates compared to other types of debt. While a mortgage may have an APR of less than 5%, most credit cards have an APR over 20%.

This essentially means that credit cards are an expensive way to borrow money. You have convenient access to funds when you need them, but you pay for it in the end.

Fixed versus variable rates

Most credit cards in Canada have fixed interest rates. This means that the interest rate stays constant and does not change based on economic conditions. The rate is set when you first open the account and generally will not change as long as you maintain the account in good standing.

However, some credit cards have variable interest rates. With these cards, the rate is tied to the Canadian Prime Lending Rate. When the Bank of Canada changes the prime rate, rates on variable-interest-rates credit lines will change as well.

Variable rates can be good when the prime rate is low. However, any increases in the prime rate can increase your cost of borrowing as well.

How credit card interest works

Credit cards have compound interest, which means that applied interest charges get rolled into the balance owed.

As a result, interest can accrue quickly, especially given that credit card interest charges compound daily. Each day that you carry a balance, a fresh round of small interest charges get applied by the creditor.

Daily periodic interest

To determine the daily periodic interest rate on a credit card, simply divide the annual percentage rate by 365. Then you can multiply that by your balance to see how much the balance costs you with each day that passes.

Let’s say you have a $1,000 balance on a credit card with 20% APR.

  • The daily periodic interest rate would be 0.05%
  • On the first day when the credit card company applies interest charges, it adds about 55 cents to your balance
  • On the second day, your balance would be $1,000 + $0.55
  • Multiply that by another 0.05% and another 55 cents gets added in
  • By the third day, your balance would be $1,001.10

With each day that passes, your balance increases slightly. This may not seem like much, but it adds up. Over one month, your balance will increase by nearly $17 even if you don’t make any new charges that month.

Interest charges vs minimum payments

One of the big challenges that credit card APR presents is how it stacks up against the minimum payment requirement.

Since credit cards are revolving debt, they have a minimum payment requirement each month. You pay a small percentage of the balance that’s currently being used, usually about 2-5%.

At the same time, you have APR of 20% or more, which compounds daily. As a result, most of what you pay covers the accrued monthly interest charges.

Let’s take that same $1,000 balance from the previous example.

  • If your minimum payment requirement is 3% of the balance owed, your minimum payment would be $30
  • However, the accrued monthly interest charges amount to $16.67
  • More than half of your minimum payment goes to cover those charges
  • In the end, you only pay off $13.33 of the balance owed

This is the trap the people fall into with credit cards. You may pay diligently every month, but most of the money goes to interest charges.

The higher your credit card APR, the worse this becomes. If you’re juggling multiple credit card balances, it can be downright impossible to make any headway paying them down.

Types of credit card interest rates

Another key point to recognize with APR is that one account may have several rates that apply in different situations.

  • Purchase Interest Rate – Purchase APR is the interest rate applied to most normal credit card transactions. When you make a purchase or shop online using your credit card, this rate applies.
  • Cash Advance Interest Rate – Cash advance APR applies to a balance incurred when you use your credit card to get cash. You may withdraw the cash at an ATM or transfer cash from your credit card to your bank account. This also includes transactions such as wire transfers and money orders. This APR is generally much higher than the purchase rate. In Canada, the average cash advance rate is nearly 23% APR.
  • Balance transfer interest rate – Balance transfer APR applies to a balance that’s transferred from another account. When you move a balance to consolidate your debt, a different rate will apply than that of normal purchases. Balance transfer credit cards offer specific advantages on transfers, including much lower APR. The goal is to get you to consolidate your existing credit card debt with a new credit card company. You get a lower rate and that company now gets the interest you pay on the balance.
  • Penalty interest rate – Penalty APR applies when you miss a payment. It usually won’t apply if you’re simply late with a payment (that incurs finance charges). But if you miss a payment entirely by more than 30 days, then the creditor applies a much higher rate. Penalty APR is usually at 30% APR or higher. With a rate this high, it’s nearly impossible to pay down your balance; every dollar gets eaten up by interest charges. If you bring your account current and show that you’re committed to making your payments on time, the credit card company may agree to restore your original rate.
  • Introductory interest rate – Introductory APR is a special low rate that a credit card company offers when you first open an account. You receive a much lower interest rate or enjoy an interest-free 0% APR period for a time, usually 6-18 months. These rates are meant to entice consumers into opening the account and using it actively. Some teaser rates may apply to a specific type of APR. For instance, balance transfer promotions may drop the balance transfer APR on the card to 0% for up to 18 months.

How grace periods affect interest charges

Every credit card in Canada has a grace period. This is an amount of time (usually 21 days) after the last day in a billing period where, if you pay your balance in full, interest charges will not apply to the balance.

The grace period typically ends on the payment due date. In other words, if you pay your balance in full by the due date, the credit card company won’t apply interest charges.

The flip side of this is that if you don’t pay off the balance in full by the end of the grace period, then interest charges apply to the full balance. That includes the part of the balance you paid off. This is the dark secret of grace periods on credit cards.

How to minimize interest charges, even with high APR

While grace periods will be to your disadvantage if you don’t pay off your balance in full, you can also use them to your benefit. To do so, you simply avoid carrying balances over from month-to-month.

If you start and end every billing cycle with a zero balance on a credit card, interest charges never apply. You can enjoy all the benefits of credit cards without the added cost.

“Carrying balances on credit cards isn’t doing you any favours,” says Jeffrey Schwartz, executive director of Consolidated Credit, “but there are budget-healthy ways to use your cards. It starts with using grace periods to your advantage.”

You can follow these steps to get started:

  1. First, you need to pay off the existing balances you have on your accounts.
    1. You may want to use a debt reduction plan to eliminate multiple balances efficiently.
    2. You will also need to balance your budget, so you can avoid new credit card charges until you have each balance paid off.
  2. Once you get each card to a zero-balance, make new charges sparingly. Only charge what you can afford to pay off each month.
  3. Also, consider finding a recurring cost in your budget that you use a credit card to cover. Then, with the money you have allocated for that expense, you pay it off in full each month.
    1. Just make sure you’re paying off the balance and not using credit as a crutch in place of income that you don’t have.
  4. If you see you’re starting to carry a monthly balance on any card, rebalance your budget and pay it off immediately.

Finding solutions to lower APR

If you start juggling multiple credit card balances at once, you will begin to spend a significant portion of your income covering interest charges. This is a bad use of credit and a recipe for financial hardship that can lead to bankruptcy.

In this situation, you may need a different strategy to pay off your debt quickly. Traditional monthly payments may not be effective. Solutions like debt consolidation and credit counselling may be needed for you to regain stability.

Talk to a trained credit counsellor about solutions to minimize APR, so you can get out of debt.

Why is high APR such an issue?

APR represents the cost of using credit. Higher APR means higher costs.

With credit cards, high APR is particularly problematic because of low minimum payment requirements. You may be required to pay off 2-5% of your balance each month. However, at the same time, 20% APR is applied to that same balance.

As a result, one-half or even up to two-thirds of every payment you make gets used to cover accrued monthly interest charges. You chip away at the debt you owe slowly. In some cases, when APR gets particularly high, it may seem like you’re making no progress at all.

Exploring methods that help minimize high APR

If you can’t make any headway in eliminating your debt, then you need a different repayment strategy. These eight options focus on lowering the APR applied to your debt, so you can pay it off more efficiently.

The first method is the easiest and most straightforward. You simply contact each creditor to request a lower APR on your account. A credit card company may agree to temporarily or permanently lower your APR.

Factors that can influence a creditor’s decision for the better:

  • Your credit score has increased since you first opened the account
  • You are a loyal customer who always pays your bills on time
  • You are not approaching the credit limit on the account

In some cases, the creditor may only agree to a temporary reduction. If so, you will need to be more proactive about paying off the balance before the rate increases again.

Another strategy that can help minimize interest charges is to prioritize debts based on APR. High APR debt costs you more with each month that passes. It makes sense that paying off the balances with the highest APR first will help you save money long-term.

Using this debt reduction strategy, you streamline your budget to eliminate any unnecessary expenses. You make the minimum payments on all your credit cards except the one with the highest interest rate. Then you devote all your extra cash to making the biggest payment possible.

Once you pay off the highest APR debt, you move on down the line.

If your credit card company is unwilling to lower the APR applied to your account, there may be another option. You may be able to set up a repayment plan. The creditor will generally require that they freeze your account, so you can’t make new charges.

In exchange, they agree to significantly lower the APR applied to your balance. You make monthly payments you can afford. In most cases, once the balance is fully repaid, the creditor will close the account.

This can be a good option for a single account that’s become difficult to manage because it is at or near the credit limit. If an account is so far gone that you would be better off to close it, consider using this option to pay off the debt.

Balance transfer cards are specialized accounts designed to consolidate existing credit card balances. These cards offer low APR on balances transferred from other accounts. They also may provide a 0% APR period for 6-18 months after you first open the card. This allows you to pay off credit card debt interest-free.

This option works well for limited amounts of debt, generally $5,000 or less. You will need a good credit score to qualify for the longest 0% APR period possible.

If you have multiple credit card balances as well as other debts to repay, you may want to consider a debt consolidation loan. This is an unsecured personal loan that you use to pay off credit cards and other existing debts.

These loans offer a lower, fixed interest rate, as well as fixed monthly installment payments. With lower APR, you may be able to get out of debt faster, even with a reduced total monthly payment.

This typically requires you to have a good-to-excellent credit score to qualify for the lowest possible interest rate.

Another option for Canadians with a strong credit profile is a personal Line of Credit (LOC). This is an open revolving credit line that a bank or credit union extends to you.

A LOC typically has a variable interest rate, but that rate is much lower than the rates available on credit cards. You can use funds from the LOC to pay off your cards and other debts.

With a LOC, the minimum payment usually only covers the accrued monthly interest charges on the portion of the balance that’s in use. This means you can enjoy low monthly payments.

However, it also means that you may never pay off debt. If you decide to use a LOC, make sure that you commit to paying down the balance, even though you are not required to do so.

Homeowners with available equity can access a specialized financing option known as a Home Equity Line of Credit. Equity is the appraised value of a home minus the remaining balance on the mortgage.

HELOCs may allow you to borrow up to 80 percent of the equity that you have available. Since the line of credit is secured using the home as collateral, you generally enjoy a low-interest rate.

You can use the funds for a variety of purposes, from using the funds for home renovations and investments to paying off credit cards and other debts. However, a HELOC should not be used solely for the purpose of paying off credit cards.

The reason is that this essentially converts debt from unsecured to secured. If you can’t keep up with credit card payments, you could face collections. If you can’t keep up with HELOC payments, you could face foreclosure. It’s simply a risk that you don’t want to take.

However, if economic conditions are good and you take out a HELOC for other purposes, there is nothing wrong with using some of the remaining funds to pay off credit card debt.

The last option for minimizing high APR is to set up a debt management plan through a  credit counselling organization. You work with a trained credit counsellor to find a monthly payment you can afford.

Then the organization contacts your creditors. They agree to accept payments through the credit counselling organization, as well as reduce or even eliminate APR.

Debt management plans are a great solution for anyone who is overwhelmed with credit card debt. There is no credit score requirement to be eligible, so you can use this solution to lower APR even if you have poor credit.

They also work for large volumes of debt, which many of the solutions listed above can’t cover.

Finding the best option for you

Determining which of these eight options is right for you will depend on your circumstances. You must take your debt amount, credit score, budget, and goals into account.

Most of these options will not prohibit you from trying another solution if you don’t see positive results. You may try calling your creditors first and if that doesn’t work, you can consider a balance transfer, debt consolidation loan, or LOC. If those fail, you may still be able to enroll in a debt management plan.

There is, however, no going back from a HELOC. Once you convert your debt to secured, your options for relief may be limited.

To avoid spending time and money on solutions that may not be successful, you should contact a credit counselling organization. A trained credit counsellor will help you evaluate your financial situation and make recommendations on your best option for relief.

A professional opinion can help ensure you’re making the right choices for your credit and that you can achieve your goal of being debt-free.

Talk to a trained credit counsellor for free to evaluate your options.

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