Credit cards can be extremely useful in day to day life, not just for making purchases but also to help build up your credit history, consolidate debt and reap the benefits of their reward schemes. However, one of the most important things to understand is how their interest rates work. Let’s take a look.
When you use your credit card for purchases and pay off your bill in full each month, it’s similar to having an interest-free loan: with the exception of any annual or monthly fees, you won’t be charged for the privilege. However, if you’re only making the minimum monthly repayments, you’ll be charged interest on the amount you still owe, and if you’re not careful this can soon add up. How this interest is calculated depends on a number of factors.
What is APR?
When shopping around for a credit card, you’ll come across the term APR (annual percentage rate). This rate represents both the interest charged on anything you borrow plus any other compulsory charges such as annual or monthly fees.
If you’re using price comparison sites, the APR is a good way to compare products. For example, if one lender is offering 18.9% APR and another 19.9% APR, the 18.9% APR is clearly a better rate. However, before choosing a product, you must also take into consideration how long this rate is valid and if there are different rates for different types of borrowing (purchases, balance transfers and cash advances), and choose the one that best suits your needs.
It’s also important not to confuse APR with AER (annual equivalent rate) which usually refers to the amount of interest you earn on money in a savings account.
Representative APR versus personal APR
In addition, the advertised rate isn’t necessarily what you’ll receive when you apply. At this stage it’s merely a ‘representative APR’ – the interest rate offered to the majority of eligible customers, which means at least 51% of people whose applications are approved.
Depending on your credit rating and the credit limit requested, your APR could end up being higher. You’ll know the exact rate – your personal APR – once your application has been approved and before you commit to taking out the credit card.
How is interest calculated?
The way you’re charged interest depends on the terms of your provider and what you’re using the credit card for. However, whoever you’re with, if you don’t pay off the full amount every month you’ll find yourself accruing compound interest. This is when you’re charged interest on both your outstanding balance and any interest already accrued. Although this may seem minimal at the start, it can soon add up, which is why it’s worth paying off the full amount every month if you’re able to do so.
Interest rate differences and changes
When you sign up for a credit card, your provider will let you know the rates for cash advances, purchases and balance transfers. These rates may be different, and some may even be interest free for a set period of time. So, if you are offered a promotional or introductory rate, make sure you know how long the rate is valid for as it’s likely to go up at a later date.
In addition, cash advances (withdrawing cash from an ATM) are generally charged at a higher rate than purchases, and interest on this will accrue from the day you make the withdrawal. Also, if your credit card provider intends to increase their interest rates, they must give you at least 30 days’ notice before this comes into effect. Then, if you don’t want to accept it, you should have 60 days in which to cancel the card and pay back the amount you owe at the existing rate.
Credit cards are a flexible and secure way to make purchases. However, if you don’t pay off your balance in full every month, you might notice debts starting to mount up. Knowing the ins and outs of interest rates helps you stay on top of what you owe whilst building up your credit rating and letting you enjoy all the additional benefits offered on your account.