MoneyMagpie

Jun 12

How does interest on a credit card work?

Credit cards have caused all sorts of financial meltdowns. Some people are downright scared of getting one because they’ve heard the horror stories of unassailable debt. However, credit cards are actually very useful and if you understand how they work then they’re completely safe and affordable to use.

The main issue you need to master is also the one most people struggle with, namely getting your head around how lenders charge interest.

APR

APR, or Annual Percentage Rate, is the key to understanding how much you’ll be charged for borrowing over a year. This number takes into account interest and all the other charges you may incur.

Interest

Interest is charged on borrowed money. It is usually labelled as APR.

Compound and simple interest

To get on top of interest, you need to understand the difference between compound and simple interest and how they affect your repayments. Here’s a simple explanation:

If you borrow £1,000 a year at 12% APR, this doesn’t mean the interest is 1% of £1,000 every month. Why not, we hear you ask? Well, the 12% APR is actually a compound rate, which means it takes into account the interest you pay on interest too, which will keep growing. What this means is that in your first month of repayment you’ll be paying £9.49 worth of interest, then £9.58 in your second month. As you can see there is interest charged on top of the interest. Bear with us and it’ll make sense.

12% vs 11.38%

So, in this case of 12% APR, the simple interest rate is actually 11.38%. To calculate the monthly interest rate you divide the annual simple interest rate by 12, which gives you a monthly interest rate of 0.949%.

So this figure, 0.949%, is applied to each month’s outstanding balance including the interest that’s already accumulated – this is called compounding. Therefore, the longer it takes to clear your balance the more you pay in compound interest, aka the interest stacks up. Hence on a £1,000 credit card balance, you’ll be charged £9.49 in interest in your first month, then if you still haven’t paid anything off, you’ll be charged £9.58 in interest in your second month, because this second month takes into account the £1,000 plus the £9.49 interest that’s been added to it.

Thus, if you don’t make any payments on the £1,000 for a whole year, by the end of that year you’ll have to pay back £1,120, because the compound interest (which includes the interest paid on interest) is 12%. 12% of £1,000 is £120. Simple, right? No, compound (wink).

APR will usually always be the compound interest rate, so bear that in mind.

There’s a twist

This is an extremely simplified example to illustrate how interest works. But, in the real world, you will usually need to pay at least a minimum amount each month, so keep that in mind, whereas this example is based on you not paying back anything each month.

Credit card interest is usually worked out daily rather than monthly.

However, don’t let that scare you off, if you understand how the interest works in our example then you understand how interest works in general and you won’t be overwhelmed when you deal with a real scenario. Credit cards are a lot simpler to understand than you might have thought, and hopefully we’ve enlightened you a little!

 

If you’re still a bit confused, check out the infographic below, with research from HSBC, for an illustrated walk through of everything we just discussed!

 

 

 

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