Credit card interest can be a complex and confusing puzzle to many of us. However, understanding how the interest works is an important part of ensuring we are staying on top of our credit card debts. While it’s all too easy to simply pay the minimum amount required each month, this is a recipe for not only prolonging the debt, but also vastly increasing the amount of interest you’ll be paying on it too – a topic covered in our online article average credit card debt takes over 25 years to repay.
Hence, we’ve outlined the important things you need to understand about how credit card interest works in this guide.
When you use your credit card, you are essentially borrowing the money from the credit card provider. The amount you spend is added to your balance and you are charged interest on this amount (unless your credit card offers 0% on purchases and you are still within the 0% period).
You will receive a credit card statement (by post or by email) each month with a due date. This is the date when you must have at least made the minimum payment by. If your balance is only made up of purchases and you clear your whole balance before or on this due date, then you will not be charged any interest. Other transactions on credit cards do not tend to have interest-free days.
However, if you pay less than the whole balance you will be charged interest on the remainder. This means the interest is added to your remaining balance, reducing the amount of what you have just paid off your card. As an equation this is:
Your balance – your repayment = net balance x monthly credit card interest rate = end of month balance
Find out more about the basics of how credit cards work in our dedicated credit card section.
All credit cards should clearly show the ‘representative APR’ (short for annual percentage rate) in their advertising. An APR is calculated using a standard formula and value across all card providers. This allows you to compare which card will charge you more. A representative APR is based on the rate at least 51% of people are actually offered. A personal APR is the actual rate a credit card provider is willing to offer you as an individual based on your credit history.
The APR is the interest rate cost plus any fees cardholders must pay to get the card, for example an annual card fee. It is calculated over 12 months – hence an annual percentage rate.
Any extra charges or fees for missing payments or cash withdrawals are not included in the APR.
The APR is calculated in the same way for all credit cards. All card providers use the same assumed credit limit and use the type of interest rate most often used by cardholders. For example, there are often different rates of interest for purchases, versus balance transfers or cash withdrawals. It is the standard purchase interest rate that is used.
This advantage of an APR is that you can easily compare credit cards inclusive of interest rates and card fees.
A representative APR uses the same calculation but is based on the credit limits and rates offered to at least 51% of cardholders. This makes it more representative for borrowers and is the figure you will see quoted on credit card adverts.
However, the APR is not necessarily a reflection of the rate you will be offered ¬– instead, this is your personal APR and is based on your credit history.
A representative APR allows you to compare credit cards. It’s always a good idea to shop around to find the lowest representative APR, as this means you’ll pay less overall if you don’t intend to pay off the whole sum straight away.
However, the actual cost you will pay is dependent on how much of your balance you pay off each month, any fees and charges you incur.
All credit cards will state a ‘minimum repayment’ for each month. This is basically the smallest amount you can repay or, to put it another way, the minimum payment to service your debt. Very often, the minimum payment will be given as a percentage figure and has a minimum value too.
For example, if a credit card has a minimum payment of 1% this means you must pay at least 1% of the total amount owed for that statement, plus interest and charges for the month.
Let’s say you have spent £1,000 on a credit card and have not had a balance on the card in the prior month. with the card’s minimum monthly repayment is 1%. This works out as a minimum monthly repayment of £10.
Some credit cards have a minimum amount they will accept. Using the example above, the minimum payment could be 1% or £15 – whichever is the greater. So, because the 1% amounts to only £10, the smallest amount you could pay would be £15, as this is greater than 1% of the total owed.
In reverse, if the same credit card had a minimum repayment of 1% or £5 – whichever was the greater – then you would have to pay the £10 owed, as this is more than the minimum amount of £5.
Interest on a credit card is calculated each month using the monthly interest rate advertised for purchases, cash advances or balance transfers. To find out how much interest you will be paying over a year, multiply the amount you owe by 12.
While a credit card may advertise a specific APR, the rate that you end up paying is dependent on several factors – not least of which is your credit score when you apply. A credit card company is only required to offer the advertised rate to just 51% of those who successfully apply – those who have a poorer credit score may still be offered a card but at a higher APR.
The current average APR for UK credit cards is around 22.5% (based on Bank of England figures). Consequently, as a rule of thumb, you should look for deals that are at or below this figure.
However, remember that credit cards often charge differing interest rates depending on what you are using your credit card for. Representative APRs are based on the interest rate for purchases you make on the card, however, the interest rates for things like transferring the balance of another credit card to another one or for cash advances will possibly much higher.
Therefore, it’s a good idea to look a little deeper before you apply and make sure that you don’t use a credit card for something that it will likely charge you more for.
Often, you’ll find that credit cards offer an interest-free period on one or more elements, such as 0% on balance transfers and purchases.
These 0% deals are often for limited periods, normally shown as months. So, a card that offers a 0% deal on balance transfers for the first 24 months means that you can enjoy no interest for two years on the transferred balance – making paying off such a debt much easier.
If you are planning on taking out a 0% interest deal, you should always try to clear the balance within the interest-free period. Once the deal ends, you may find that the rate you’ll be paying will likely rise sharply. So be prepared or transfer to another 0% credit card deal before the introductory period ends.
Always remember that, as well as interest, credit cards may also charge you fees for certain purposes – such as if you use your card abroad, withdraw cash, transfer a balance from another card or if you fail to make a payment on time.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.