Understanding how credit card interest rates work is essential if you are thinking about applying for a card.
Interest rates ultimately determine how much a credit card will cost to use, but they are more complicated than the headline rates may lead you to believe.
Choosing a credit card simply by comparing the advertised interest rates is also not advisable, since there are many other things to consider as well. With most credit cards, you won’t actually have to pay anything in interest, provided that you pay off the bill in full every time.
However, people often don’t do this, so it is important to know just how much it is going to cost you to keep a debt on the card for a certain period of time. The following seeks to explain how lenders calculate their interest rates.
What is Annual Percentage Rate (APR)?
Credit card interest rates are usually quoted in terms of an annual percentage rate. These rates are a rough indication of how much borrowing money with this credit card will cost you over the course of a year.
For example, borrowing £1000 on a card with a 20% APR will in theory cost you £200 each year. Enter your details in our calculator to see what your debt will cost:
Understanding the costs of APR
While APR is important to consider when choosing a credit card, it should not always be taken literally, since there are many other important things to look at.
APR for credit cards can be as high as 39.9%, although the highest rates are only found in credit cards designed for people with poor credit ratings. If you have a good credit history, you will pay far less in interest and there are many cards with low APRs of less than 10%.
APR does not take into account compounding interest rates – this is typically calculated monthly rather than yearly. In reality, you will usually pay slightly more than the annual rate due to the fact that you will have to pay interest on the interest debt itself.
APR also doesn’t take into account any other fees which you might be charged by the lender, although most credit cards in the United Kingdom do not charge a monthly usage or administration fee unless they provide some additional benefits.
Purchase rates vs cash advance
The APR quoted with a credit card usually refers to the interest rates charged on purchases. After all, this is what credit cards are most commonly used for. Most lenders will charge different rates for different transactions.
For example, cash withdrawals on credit cards are usually charged higher interest rates, and interest is also likely to be charged as soon as you withdraw the money rather than a month or more later.
Balance transfers may also be charged at a separate rate. Many credit cards actually allow you to transfer existing debts for a one-time fee and not pay any interest on that debt for a period of time.
Another term you will often come across when shopping around for credit cards is ‘Representative APR.’ APR is often calculated based on the risk factor involved. This means that those with poorer credit histories will often be charged a higher APR.
By contrast, the representative APR refers to the rate which the bank charges to the majority of its customers. In the UK, credit card issuers have to offer their advertised (representative) interest rates to at least two thirds of their customers.
Important Questions to Ask Yourself
It is important not to rely solely on the advertised rates when choosing a new credit card, since there are many other important things to consider. Be sure to take the following questions into account when shopping around for a new card:
- Is there an interest-free balance transfer facility? If so, what it the one-time fee to transfer the debt and how long does the interest-free period last?
- Is there an interest-free period on purchases?
- Are there any additional fees, such as monthly administration fees or extra charges for using the credit card in a foreign country?
- What is the minimum repayment rate on the card? For most credit cards, it will be around 5% or £5 (whichever is higher). However, you should also get into the habit of paying off the debt as quickly as you can.
- Does the credit card charge interest on interest (compounding interest)? Most card issuers do charge compounding interest, although there are a few exceptions.
- Low rate APR credit cards – Are you better off with a low rate APR credit card or one with introductory benefits?
- How Is Credit Card Interest Calculated How Is Credit Card Interest Calculated