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How is credit card interest calculated?

How is credit card interest calculated?

Do you know how your credit card’s interest rate is calculated? Read our guide on credit card interest to learn more.

While it may be the most important feature of your card, determining how much your borrowing costs you, few of us really understand how our credit card interest rate is calculated.

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We explain how to calculate interest rates on your current credit card to make sure you aren’t paying over the odds. If you're new to credit cards you can read up on how credit cards work to get to grips with the basics.

Our credit card calculator can explain how much you're paying on your credit card and how long it will take you to pay off your balance:

How to calculate credit card interest rates

Your credit card works as a lending machine, the money you spent on it is borrowed and in turn you have to pay a fee.

This fee is calculated as a percentage of the amount you borrow and is calculated at specific times. The amount you owe for interest one month is then added to the total amount you owe until you can clear your balance.

Just to make things complicated though, the way the interest you owe is calculated can vary between card providers. However, using an interest rate calculator you can estimate the amount you owe.

Interest rates are most commonly expressed as APR or ‘annual percentage rate’, but don’t be confused by the use of the word ‘annual’. While APR helps you to compare costs by averaging out the total costs over the year, interest is charged on a monthly basis.

However, even if you know how much interest you have paid each month, working out your current interest rate depends entirely on which calculation your bank uses, and even an interest rate calculator can’t give you the exact amount.

The best way to know the exact interest rate is therefore to contact your bank or financial services provider.

How is credit card interest calculated?

Minimum repayments

Regardless of how your interest rate is calculated there are some simple rules your should follow to ensure you don’t owe your card provider more than you should.

The first is minimum repayments, a credit card feature that may start out seeming like your best friend but quickly turn into your worst enemy.

Minimum repayments are a minimum amount you have to repay on your credit card each month to ensure your credit file remains unharmed and your lender doesn’t pursue you.

While this may sound good in principle – particularly if you’re short on savings – the low level of minimum repayments means your debt is stretched out over a longer period of time, meaning you pay more in interest.

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Under new legislation introduced in 2011, minimum repayments now have to be at least 1% of your balance plus any interest, as opposed to being interest only like some mortgages.

Thankfully this means that, no matter how hard you try, you will pay off your credit card balance eventually. However, as it is calculated as a percentage of your balance the speed of repayment decreases over time as you pay less and less.

Credit card repayment

Rather than finding yourself stuck in this cycle, a far better option is to repay your balance in full as soon as possible. Quite simply, the quicker you pay off your balance the less it will cost you in interest.

Unfortunately credit cards are often a last resort used for large purchases that can’t be covered in one payment – over Christmas say or for large purchases – meaning they can’t be paid off immediately.

If that’s the case your first step should be to set up a Direct Debit of a fixed amount that you can afford each month. Estimate how long it would take you to pay off your balance by paying back different amounts. Once you find the right amount – both in terms of affordability and interest repayments – you can set up your Direct Debit.

If you can’t afford to set up a Direct Debit for a fixed amount don’t worry. You can still set up a payment for the minimum amount and make additional payments to work off your balance when you can afford them.

A monthly Direct Debit is not only essential to ensure you pay back your debt, it’s also vital to ensure your credit history stays in order.

Every debt you hold is kept on file by credit reference agencies who are used by lenders to assess the risk of lending to their customers. If you miss a minimum repayment to your credit card not only will you be fined – typically £12 – but you will also have a mark on your credit file.

This can impact your future lending and means you may be ineligible for cheaper 0% deals.

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If you are finding your repayments are to high, or your interest rate is higher than it should be, you may be better of with a 0% balance transfer credit card.

A 0% transfer card lets you move your debt from one card to another and can be a good way to avoid excessive interest payments, but there are a few basic rules to follow.

First of all make sure you know how long the 0% period lasts for, as once it expires you’re likely to find yourself paying a high level of interest. Keep in mind though that even when the period expires you could still move to another deal, providing your credit history is in good shape.

You should also check the balance transfer fee – typically a percentage of the amount you owe – which is charged when you move your debt. And finally, it may sound obvious, but don’t use your 0% card for spending, regardless of how tempting it is. The whole point is to reduce the amount you owe.

Stoozing - exploiting interest rates

It's possible to exploit the difference between the interest you are charged to borrow and the rate you are paid for your savings. In particular using 0% interest periods to make money is called stoozing.

However, it's not simple; you have to find the best bank accounts, lowest transfer fees and carefully manage your card payments.

Read more …

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