How interest works on debt (APR in plain English)

Resources · Debt basics · 5 min read Starting out

Key points

• Interest on debt is the price you pay for borrowing money, charged on what you still owe.
• APR is the yearly rate. Many debts charge roughly one-twelfth of it each month.
• Interest is worked out before your payment comes off, so it bites first.
• Paying more each month shrinks the balance faster, which cuts the interest too.

What interest on debt actually is

Interest on debt is simple at heart. When you borrow, the lender charges you for using their money. That charge is interest.

It isn’t a one-off fee, though. It gets charged again and again on whatever you still owe. Big balance, big interest charge. Small balance, small one. Hold onto that link, because almost everything else in this article comes back to it.

What APR means

APR stands for annual percentage rate. It’s the yearly cost of borrowing, shown as a percentage of the balance.

You’ll see it on credit cards, personal loans, car loans and plenty of other debts. The rules about what has to be included in an APR can differ from country to country. The core idea doesn’t. A higher APR means borrowing costs you more.

Keep two things in mind. First, APR is yearly, but you’re charged monthly. Many debts work with a monthly rate, so a 20% APR becomes about 1.67% a month (20 ÷ 12). Others use a daily rate, which comes out close. Second, some debts carry more than one APR. A credit card might charge one rate on purchases, a higher one on cash withdrawals, and something different again during a promotional period.

Some lenders work interest out daily instead. The answer ends up close to the monthly version, so the monthly method is still a good way to understand what’s happening.

A worked example

Take a credit card with:

• a balance of $5,000
• an APR of 20%
• a fixed payment of $200 a month
• interest charged monthly on the balance, before the payment comes off
• no new spending on the card

The same maths works in any currency.

Month one. The monthly rate is 20% ÷ 12 = 1.6667%. Interest on $5,000 is $83.33. So of your $200 payment, $83.33 goes on interest and only $116.67 actually reduces the debt.

After a year. You’ve paid $2,400. Of that, $864.25 went on interest. The balance is now $3,464.25.

By the end. It takes 33 months to clear (the last payment is smaller), and you pay $1,522.13 in interest in total.

Now bump the payment up to $300 a month and keep everything else the same:

An extra $100 a month clears the debt 13 months sooner and saves $615.31 in interest. Why? Each extra dollar shrinks the balance, and a smaller balance attracts less interest next month.

Why the yearly cost can be higher than the APR

Interest is charged every month. So if the balance isn’t coming down, you end up paying interest on last month’s interest. Over a full year, a 20% APR charged monthly on an untouched balance works out to about 21.94%.

That’s compounding. In a savings account it works for you. On debt it works against you. Pay at least enough to cover the interest each month, or the balance grows.

How to read your own rates

Your statement or loan documents should show the APR (or APRs) on each type of balance, the interest charged this month in dollars, and any promotional rate along with the date it ends.

Look at the dollar figure, not just the percentage. “$83.33 this month” hits harder than “20%”. Some people add up the interest across all their debts every month, just to see what owing money really costs them. It’s a sobering exercise, and a useful one.

What makes interest smaller

There are only a few levers. Which ones you can pull depends on your situation.

A lower balance is the first. Every payment above the interest charge cuts next month’s interest. A lower rate is the second. Moving a balance to a lower-rate product, for example with a balance transfer, changes the cost, though fees and end dates matter. And then there’s time. The sooner a balance is gone, the fewer months it has to attract interest.

If you can’t cover your repayments right now, free debt help is available, and it’s confidential.

Common questions

What does APR mean?

APR stands for annual percentage rate. It’s the yearly cost of borrowing, shown as a percentage of the balance, and many debts charge roughly one-twelfth of it each month.

How is interest on debt calculated each month?

The APR is split into a monthly rate, usually by dividing by 12. That rate is charged on the balance before your payment comes off. Some lenders work it out daily, which gives a similar result.

Why does paying more reduce the interest?

Each extra dollar shrinks the balance, and a smaller balance attracts less interest next month. In the example above, an extra $100 a month saved $615.31.

Try it

Put your own balance, rate and payment into the credit card payoff calculator to see your months and total interest. To see every debt together, find your Freedom Date.

General information only, not financial advice. Your situation is your own.