Penalty Annual Percentage Rate (APR)

You’re probably most familiar with credit card APR (annual percentage rate) as the interest charged on purchases and other transactions. A penalty APR is a higher-than-normal rate that results from violating a card’s terms of service — for example, if you fail to pay your monthly bill on time. It’s costly, harmful to your credit and commonly takes months to resolve. Fortunately, there are ways to avoid it.

How penalty APR works

A penalty APR is triggered when you make late payments, your payment is returned because of insufficient funds or a closed account, or you exceed your credit limit. Each credit card issuer has specific conditions that must be met for a penalty APR to go into effect. When a penalty APR is triggered, your standard APR rate is replaced by the penalty APR, which will likely be much higher.

The good news is that credit card issuers can’t charge a penalty APR arbitrarily. With credit card APR, it’s important to remember the numbers 21, 45 and 60:

• 21. You have a 21-day grace period from the end of a billing cycle before your card’s standard APR applies to an unpaid balance.
• 45. Federal law requires the issuer to give you 45 days’ notice before applying a penalty APR.
• 60. The penalty APR generally comes into play when an outstanding balance hasn’t been paid in full for more than 60 days.

Read your credit card’s terms and conditions to see when you might be subject to a penalty APR and what the higher rate is. Do the same with any new cards before you apply for them.

Insight

Don’t confuse “0 percent intro APR” with “no penalty APR.” The best zero-interest credit cards help you to avoid a card’s regular APR on purchases and/or balance transfers for a limited time, but they won’t help you to avoid penalties for late payments.

How long does a penalty APR last?

If you get serious about paying off your balance, the penalty APR could last as little as six months. Federal law requires your credit card issuer to review your account once you’ve made six consecutive on-time payments. The easiest way to return to the standard APR is to address the underlying reason behind the penalty APR.

There are certain factors that will determine whether your standard APR is reinstituted, such as paying off the minimum balance, not making late payments and staying within your credit card limit. If you continue to run the outstanding balance, however, the penalty APR could stay in place indefinitely.

Does triggering a penalty APR affect your credit?

Yes, a penalty APR can adversely impact your credit score. Under the FICO scoring model, repeated late payments will impact the payment history category. Payment history — including credit card accounts — makes up 35 percent of your score. A record of making late payments can weaken that pillar.

Payments that are returned due to closed accounts and insufficient funds can also influence your payment history. And exceeding your credit limit would result in a high credit utilization ratio, which accounts for 30 percent of your FICO score.

How is penalty APR calculated?

The penalty APR is usually a predetermined rate you can find in a card’s terms and conditions. Factors like your credit card balance or your credit score don’t typically determine the penalty APR.

Most credit card issuers limit their penalty APRs, but the limit is usually a whopping 29.99 percent. That rate is nearly twice as high as the average credit card APR, which is around 19 percent, and almost certainly a lot higher than your standard APR.

Keep in mind that if you avoid the penalty rate, late payments can still cost you in other ways. After the 21-day grace period ends, you’ll pay interest on an outstanding balance in the form of your card’s standard APR. You might also have to pay late fees.

What to do if you’re being charged a penalty APR

Here are some measures you can take to lessen your debt if you’re currently being charged a penalty APR:

• Call the issuer. Be proactive and explain the backstory on missed payments. This isn’t a guarantee that the penalty APR will be reduced, but it doesn’t hurt to present your side.
• Check your credit card agreement. Be sure to understand how your credit card issuer deals with late payments and how the penalty APR applies to your balances.
• Limit using this credit card and pay off balances as soon as possible. If you’re not able to get rid of the penalty APR, you want your balance as low as possible. Try to only charge what you can afford and make sure to pay on time.
• Get organized. To break the cycle of late payments, you’ll need to frequently check your balances and set reminders for payment dates.
• If you can’t pay off the balance, consider transferring and applying for a balance transfer credit card. Look for a balance transfer credit card to lessen the burden of carrying debt with a penalty APR.

How to avoid penalty APR

As outlined in the following tips, good financial habits could prevent a lapse in your payment routine (which opens the door to a higher interest rate).

• Don’t carry a balance. The best way to avoid a penalty APR is simple: pay your monthly credit card bill in full and on time. You might be able to avoid a penalty APR temporarily by making a minimum monthly payment, but unless you get your entire balance squared away in a timely manner, you could just be buying time.
• Consider automatic payments. Many credit card issuers offer the option of automatic payments so that you can set a date and put your payments on autopilot. The payments are connected to your bank account, and you can choose to make a full or minimum payment (full payment is recommended).
• Set reminders. If you’d rather not use automatic payments, set reminders for yourself. You can do it on your phone or computer, set text or email reminders through your issuer, or take the old-school approach with a circled date on a calendar or a sticky note on your monitor.
• Choose a card without a penalty APR. As a safeguard, you might want to consider a credit card that doesn’t charge a penalty APR, some of which are listed below. Although some no-penalty-APR cards are comparable to other options, the potential tradeoffs could include lower credit limits or fewer rewards.

Types of APRs

Credit card APRs vary based on the type of charge. The credit card issuer may charge one APR for purchases, another for cash advances, and yet another for balance transfers from another card. Issuers also charge high-rate penalty APRs to customers for late payments or violating other terms of the cardholder agreement. There’s also the introductory APR—a low or 0% rate—with which many credit card companies try to entice new customers to sign up for a card.

Bank loans generally come with either fixed or variable APRs. A fixed APR loan has an interest rate that is guaranteed not to change during the life of the loan or credit facility. A variable APR loan has an interest rate that may change at any time.

The APR borrowers are charged also depends on their credit. The rates offered to those with excellent credit are significantly lower than those offered to those with bad credit.

APR does not take into account the compounding of interest within a specific year: It is based only on simple interest.

APR vs. Annual Percentage Yield (APY)

Though an APR only accounts for simple interest, the annual percentage yield (APY) takes compound interest into account. As a result, a loan’s APY is higher than its APR. The higher the interest rate—and to a lesser extent, the smaller the compounding periods—the greater the difference between the APR and APY.

Imagine that a loan’s APR is 12%, and the loan compounds once a month. If an individual borrows $10,000, their interest for one month is 1% of the balance, or $100. That effectively increases the balance to $10,100. The following month, 1% interest is assessed on this amount, and the interest payment is $101, slightly higher than it was the previous month. If you carry that balance for the year, your effective interest rate becomes 12.68%. APY includes these small shifts in interest expenses due to compounding, while APR does not.

Here's another way to look at it. Say you compare an investment that pays 5% per year with one that pays 5% monthly. For the first month, the APY equals 5%, the same as the APR. But for the second, the APY is 5.12%, reflecting the monthly compounding.

Given that an APR and a different APY can represent the same interest rate on a loan or financial product, lenders often emphasize the more flattering number, which is why the Truth in Savings Act of 1991 mandated both APR and APY disclosure in ads, contracts, and agreements.

A bank will advertise a savings account’s APY in a large font and its corresponding APR in a smaller one, given that the former features a superficially larger number. The opposite happens when the bank acts as the lender and tries to convince its borrowers that it’s charging a low rate. A great resource for comparing both APR and APY rates on a mortgage is a mortgage calculator.

APR vs. APY Example

Let's say that XYZ Corp. offers a credit card that levies interest of 0.06273% daily. Multiply that by 365, and that’s 22.9% per year, which is the advertised APR. Now, if you were to charge a different $1,000 item to your card every day and waited until the day after the due date (when the issuer started levying interest) to start making payments, you’d owe $1,000.6273 for each thing you bought.

If you only carry a balance on your credit card for one month’s period, you will be charged the equivalent yearly rate of 22.9%. However, if you carry that balance for the year, your effective interest rate becomes 25.7% as a result of compounding each day.

APR vs. Nominal Interest Rate vs. Daily Periodic Rate

An APR tends to be higher than a loan’s nominal interest rate. That’s because the nominal interest rate doesn’t account for any other expense accrued by the borrower. The nominal rate may be lower on your mortgage if you don’t account for closing costs, insurance, and origination fees. If you end up rolling these into your mortgage, your mortgage balance increases, as does your APR.

The daily periodic rate, on the other hand, is the interest charged on a loan’s balance on a daily basis—the APR divided by 365. Lenders and credit card providers are allowed to represent APR on a monthly basis, though, as long as the full 12-month APR is listed somewhere before the agreement is signed.

Disadvantages of Annual Percentage Rate (APR)

The APR isn’t always an accurate reflection of the total cost of borrowing. In fact, it may understate the actual cost of a loan. That’s because the calculations assume long-term repayment schedules. The costs and fees are spread too thin with APR calculations for loans that are repaid faster or have shorter repayment periods. For instance, the average annual impact of mortgage closing costs is much smaller when those costs are assumed to have been spread over 30 years instead of seven to 10 years.

Lenders have a fair amount of authority to determine how to calculate the APR, including or excluding different fees and charges.

APR also runs into some trouble with adjustable-rate mortgages (ARMs). Estimates always assume a constant rate of interest, and even though APR takes rate caps into consideration, the final number is still based on fixed rates. Because the interest rate on an ARM will change when the fixed-rate period is over, APR estimates can severely understate the actual borrowing costs if mortgage rates rise in the future.

Mortgage APRs may or may not include other charges, such as appraisals, titles, credit reports, applications, life insurance, attorneys and notaries, and document preparation. There are other fees that are deliberately excluded, including late fees and other one-time fees.

All this may make it difficult to compare similar products because the fees included or excluded differ from institution to institution. In order to accurately compare multiple offers, a potential borrower must determine which of these fees are included and, to be thorough, calculate APR using the nominal interest rate and other cost information.

Why Is the Annual Percentage Rate (APR) Disclosed?

Consumer protection laws require companies to disclose the APRs associated with their product offerings in order to prevent companies from misleading customers. For instance, if they were not required to disclose the APR, a company might advertise a low monthly interest rate while implying to customers that it was an annual rate. This could mislead a customer into comparing a seemingly low monthly rate against a seemingly high annual one. By requiring all companies to disclose their APRs, customers are presented with an “apples to apples” comparison.

What Is a Good APR?

What counts as a “good” APR will depend on factors such as the competing rates offered in the market, the prime interest rate set by the central bank, and the borrower’s own credit score. When prime rates are low, companies in competitive industries will sometimes offer very low APRs on their credit products, such as the 0% on car loans or lease options. Although these low rates might seem attractive, customers should verify whether these rates last for the full length of the product’s term, or whether they are simply introductory rates that will revert to a higher APR after a certain period has passed. Moreover, low APRs may only be available to customers with especially high credit scores.

The bottom line

Penalty APR isn’t inevitable. Be sure to make your credit card payments on time each month to not only avoid penalty APR, but also to avoid late fees and damage to your credit score. If you’re worried about the possibility of triggering a penalty APR, it would be a good idea to consider a credit card that doesn’t impose a penalty rate. Although you’ll still be responsible for fees and interest charges, your APR won’t increase as a result of your account activity.