How does credit card interest work?

While credit card interest can be complex, it is imperative to understand to manage your finances. Paying off the minimum payment each month may be simple, but it is a recipe for building unmanageable debt in the future.

Below we have explained how credit card interest works, so you can effectively and efficiently organise your finances.

The key to understanding how credit card interest works, and therefore how to manage your card effectively can be found on your statement. This document is usually sent to you by post, email, or online banking each month and provides an overview of your spending habits.

Included in this statement are several key pieces of information, first being a balance, or the total money you owe to the provider. This figure is calculated by adding the amount you have borrowed since the last statement, any outstanding money owed, interest, and fees among other charges.

The next important figure to note is the rate of interest charged on your card. This is important, as it is only applied to balances you have not paid off entirely. In other words, if you pay off your entire balance each month then you will not be charged this rate of interest.

This leads to the third key piece of information on your statement, the due date. This is the date by which you need to have made the minimum payment on your credit card. If you miss this date then your lender will make a black mark on your credit rating, which will hamper your chance of receiving further lending in the future.

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 standard interest rate cost for making purchases 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. Introductory offers of 0% interest are not included in the calculation.

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 representative 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.

1. Pay off your balance every month or, if you are unable to do so, make more than the minimum payment.
2. Look to switch your balance to a 0% balance transfer card – remember there may be a transfer fee.
3. Set up a direct debit to make sure you avoid missing a payment.

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 2% this means you must pay at least 2% 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 2%. This works out as a minimum monthly repayment of £20.

Some credit cards have a minimum amount they will accept. Using the example above, the minimum payment could be 2% or £25 – whichever is the greater. So, because the 2% amounts to only £20, the smallest amount you could pay would be £25, as this is greater than 2% of the total owed.

In reverse, if the same credit card had a minimum repayment of 2% or £5 – whichever was the greater – then you would have to pay the £20 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.

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.