How is credit card interest calculated?
Credit cards are part of daily life for many people. They allow us to stretch our finances until payday, purchase larger items without needing the upfront cost in our account, and can be a way to build your credit rating to make things like getting a mortgage easier. In the UK in 2022, there were around 53 million credit accounts open, which just goes to show how common they are. The same research predicts that there will be 63.64 million credit card accounts by 2025.
Credit cards can be useful when used correctly, but they can also be confusing. When you don’t understand clearly how credit cards work, it can be easy to fall into debt, which in turn means you owe more money that you spent in the first place, due to interest. Interest is the charge that your lender adds to your account for borrowing money.
In this guide, we’ll explain how credit card interest is calculated, as well as discussing tips for reducing the fees you have to pay.
- How do credit cards work?
- Understanding the difference between interest vs APR
- Types of APR
- How is credit card interest calculated?
- Step 1: work out your daily APR
- Step 2: calculate your average daily balance
- Step 3: multiply your daily rate and your average balance
- Step 4: Multiply the result by the number of days
- What about compound interest?
- How can you avoid paying interest on your credit card?
- Can you lower your APR?
- Repaying in full
- Increase your payments
- Make more than one payment per month
- Choose a 0% balance transfer card
- Useful links
How do credit cards work?
Credit cards allow you to borrow money, up to a certain limit, to be repaid either in full at the end of the month or over time via minimum payments. Essentially, it’s a flexible lending system – you can borrow money on demand from your bank, up to a pre-agreed amount.
They can be useful for buying items that you don’t quite have the cash for, allowing you to spread the cost over time. However, they do have several other purposes:
- Emergency finance. If something goes wrong suddenly, such as your car needing a full set of tyres, or your boiler breaking, a credit card can allow you to pay for these repairs without having to have the funds in your current account. Whilst it can be helpful to have an emergency fund in place, a credit card gives you the option to spread the cost over a longer period of time, rather than wiping out your savings.
- Protecting your purchases. In an ideal world, nothing would go wrong with any purchases you make, but sadly this isn’t always the case. Using a credit card may give you more protection than a debit card on purchases between £100 and £30,000 under Section 75 of the Consumer Credit Act.
- Balance transfers. If you have debt in several different places, a credit card may allow you to consolidate this into one account. This will make it easier for you to keep track of your payments, and may reduce the amount you pay in interest.
- Cash withdrawal. You can also use your credit card to withdraw money from an ATM, but there is usually a fee for this, so it should only be done if totally necessary. However, it may be helpful to have this option in an emergency situation.
When you apply for a credit card, your lender will assess your existing credit score and your personal circumstances to determine your credit limit. There are some things you can do, such as registering to vote, having your name on a bill statement and having a job which can all encourage your lender to look at your first credit card application more favourably.
Over time, you may be able to apply to raise this limit, depending on your payment history. However, if you’re unsure that you’ll be able to manage a credit card responsibly, it’s always better to keep your credit limit lower.
Understanding the difference between interest vs APR
When researching credit cards, you’ll likely see the term APR. APR stands for annual percentage rate, which is a figure that can be used to calculate how much an outstanding balance on your card will cost you per year. It incorporates the monthly interest rate as well as any compulsory fees you have to pay.
When you apply for a credit card, you’ll be told a ‘representative APR’, to give you an idea of what the rate might be, but it’s important to note that lenders can’t confirm the APR until you actually go through the application process. It’s simply there to help you compare different deals and give you an understanding of how much you might pay. In some cases, lenders may use a representative APR range, with applicants with the best credit score offered the best deals.
Representative APR doesn’t include fees for late payments or going over your credit limit, as these costs can vary. You will start paying APR on the outstanding balance on your card after the agreed interest-free period, which varies from card to card.
In comparison, the interest rate on your credit card is the monthly percentage you pay on the outstanding balance on your account. In summary:
|Is calculated annually||Is calculated monthly on a credit card|
|Includes fees||Does not include fees|
Types of APR
Whilst APR is a bracket term used across all credit cards, there are specific types of APR it can be useful to be aware of. These are:
- Purchase APR. This is the standard APR that you probably think of when you consider your credit card. It’s the rate you pay on the outstanding balance on your account, after the grace (interest free) period has passed. In the UK, this is typically around 56 days.
- Balance transfer APR. This is the rate that you pay on balances that you’ve carried across from other cards, where you’ve consolidated your debt. This may be the same percentage as your purchase APR, but that’s not always the case, as lenders will decide based on your credit history or any promotions.
- Cash APR. This type of APR covers cash withdrawals on your credit card. As we’ve mentioned, you should use your credit card for cash as a last resort – this APR is typically higher than your purchase APR, meaning that you’ll pay more than you withdraw.
- Penalty APR. The penalty APR occurs when you miss a payment on your credit card. Most accounts will give you a certain grace period, but if you miss this second deadline then this high percentage APR will be applied to your balance.
- Promotional APR. Some lenders will be able to offer a promotional APR when you first sign up for a credit card with them. This is typically a low rate that lasts for a specific amount of time, so if you’re looking to get a card for work on your house, or a certain purchase, it can certainly be worth looking out for this to get the best deal.
How is credit card interest calculated?
If you want to understand exactly how much you’re paying on your credit card, then you’ll need to understand how your interest rate is calculated. This can also be useful if you’re looking to reduce your credit card balance, or make an informed decision about using one to borrow over a long period of time. Let’s take a look at the process.
Step 1: work out your daily APR
As we’ve discussed, your APR is an annual percentage, not a daily one. So whilst it’s helpful for comparing deals, it needs to be broken down in order to be useful when it comes to calculating your interest rate. To do this, take your APR number, and divide it by the number of days in a year, since credit card interest is calculated on a daily basis. This sum will give you the daily rate, which is also referred to as the periodic interest rate.
For example, if your APR rate is 22%, the calculation will be 0.22 / 365, which equals 0.000602.
Step 2: calculate your average daily balance
Since the interest on your account is calculated daily, you’ll need to calculate how much your balance is each day. For the process of calculating your interest rate, it’s best to use your average daily balance.
So, get out your credit card statement, and add up all of the daily balances in the billing period, including any amounts carried over from the previous month. You should also include any fees. Then, divide this number by the number of days in the billing period to give you the daily average amount on your account.
Step 3: multiply your daily rate and your average balance
Once you have your daily APR and your average daily balance, the next step is to multiply these two numbers together.
For example, if your average daily balance is £150, you’ll need to multiply 0.000602 (the daily APR from step 1) by £150. The result is 0.0903.
Step 4: Multiply the result by the number of days
Once you have the result of step three, you can multiply this by the number of days in the billing cycle. This final number will tell you approximately how much you will be charged in interest for that time period.
For our example, we’ll assume the number of days in the billing cycle is 30. This means that the calculation will be 0.0903 x 30. The result is 2.709, or approximately £2.71 (rounded up) in interest for this billing period.
What about compound interest?
Whilst the above steps give you an approximate interest charge, they do not take into account compound interest. Since the interest figure is calculated daily, this is then added to your balance. So the following day, you’ll be paying interest on the balance you had, but also the interest that was already added to it the previous day. This is known as compound interest – essentially, paying interest on interest.
Without an online calculator, or working out the rate day by day longhand, it’s hard to adjust for this when calculating your interest rate. However, the above calculations give you an approximate idea of how much you can expect to pay.
How can you avoid paying interest on your credit card?
Now that you know how to calculate your interest rate, let’s take a look at how you can reduce this figure to lower the amount that you pay.
Can you lower your APR?
One of the first options that may come to mind is getting a lower APR, since this will reduce your interest rate in turn. If you have a good credit score, or have improved your score significantly, it can certainly be worth reaching out to your lender to see if they will give you a more favourable rate. However, this may not always be possible.
Repaying in full
Repaying your card balance in full each month is the only way to avoid interest completely, since your balance will be nil. If you’re using the card purely to increase your credit score, or to tide you over until payday, you may want to consider setting up a direct debit from your current account to your credit account, so that the balance is paid off without you having to think about it. This will also reduce the risk of you missing a payment, and looks good on your credit history.
However, it is important to remember that you will need the full amount in your current account, otherwise you may have your credit payment rejected due to insufficient funds, or go into your overdraft, which will likely have its own penalty fees.
Increase your payments
The more you pay back, the lower the balance left is, reducing your interest payments. If you can’t afford to pay back your full balance, then try to pay as much as possible, rather than just the minimum amount. Especially with compound interest, this will significantly impact the amount that you pay back overall.
Make more than one payment per month
If you make a set monthly payment on your credit card, but find yourself with some extra money later down the line, then making a second payment can also help. This is because it reduces your average daily balance, thus reducing your interest payments overall. As well as setting up your monthly payment, set a reminder to yourself to check if you can make another payment later in the month.
Choose a 0% balance transfer card
If you have a large amount of debt, you may want to consider exploring 0% balance transfer cards. This will mean you can transfer your debt to the new account, but not pay the higher rate of interest you usually would with a balance transfer. These cards will usually offer you 0% interest for a certain period of time, so make sure that you understand the terms and conditions before signing anything. They can be a good way to give yourself more time to gather the funds to pay off your debt, but are not a long term solution.
Alex Hasty - Insurance comparison and finance expert
At Compare the Market, Alex has had roles as Commercial Associate Director, Director of Trading and Director of Growth. He’s currently responsible for the development and execution of Comparethemarket’s longer-term strategic options, ensuring the right breadth of products and services that meet customer needs.