How Does Credit Card Interest Work?

You might notice that your monthly payments do not exactly reflect the amount you owe to certain creditors. If pay the minimum, you will notice that you’re monthly payments would be considerably more than the original loan.

This is what is simply called an interest. It is something that many credit holders often fail to understand properly or, worse, underestimate. Dealing with interest rates is part of the challenge of being a credit holder. To be successful at that, you have to understand how credit card interest rates work.

 What’s an Interest Rate?

An Interest rate does not only affect your credit card transactions on a short-term basis, it goes beyond that. The proper term for interest as far as credit is concerned is the Annual Percentage Rate or APR.

This number can vary from one person to another. It can also be determined by factors such as the person’s last known credit score. Also, credit card companies can actually use it to calculate your charges on a month-to-month basis.

Just exactly how is it calculated? It’s actually easy. If you want to know how much you are being charged per day for interest, just get your last APR and divide it by the number of days in a year or 365.

So, if you got an APR of 10%, your daily interest rate is at 0.027%. Now, this daily interest rate is added to your remaining balance at the end of each day. This is what is called compounding and the process goes for a cycle of 30 days or a month. So, let’s say that a credit card has a balance of £2,000 for that month with an APR of 10%. The daily interest is at 0.27% which means that an amount of £0.54 in interest is added to the overall amount per day. This process is done over and over for the next 4 weeks which leaves you with a payment of approximately £2,016.2 in the next billing period.

What’s the Problem?

So, what’s the big fuss of having to pay a few extra pounds in monthly payments, you may ask? Interest is not actually a problem when it comes to one-time payments. It is during installment-type payments that you’d notice just how much interest rates take from you on a monthly basis.

So, what if you got a debt worth £5,000 with an APR of 20%? This means you have a daily interest charge of 0.013% which equates to £0.65 per day. At the end of the month, you’d have to pay the minimum payment plus an accrued daily interest of £19.50.

So, if you’re obliged to pay £1,000.00 per month, then that means you’d have to pay an extra of nearly £20.00 for the next 5 months or a total of £100.00. That amount could have been sent directly to your savings were it not for the interest. This problem can be compounded even further if you have multiple debts to pay such as your monthly utility bills, gym memberships, and other financial obligations.

Is Interest Always Applied?

Here’s a secret that many credit issuers don’t want you to know about: interest is not actually put immediately into effect. Most of the time, credit card companies employ a grace period of sorts wherein you can pay only the amount you owed to the company bar any interest. That grace period spans from the moment that you incurred the debt to its due date. This means that if you can pay your dues on or before the date when you are required to do so, you might not have to deal with interest at all.

Of course, this means that you also forfeit the grace period if you opt to not pay or miss the due date. Often, these interest rates will appear in the next statement billed to you. To know if you can avail of a grace period for your payments, always check the terms of agreement you have signed with that creditor.

0% Interest Cards

Not all credit cards that you apply for have interest rates. In most cases, going for an 0% interest card is a good strategy in dealing with your debt. There are even certain instances when applying for a 0% interest card is recommended.

1. When You’re Dealing with Multiple High Interest Debts

It’s often said that the interest rates are what’s making payment of debts hard or near impossible. This is quite true if you have more than one onerous debt to pay and most of them feature daily interest charges going in between 0.020% to 0.10%.

By transferring to a 0% interest credit card, you can now consolidate all of your debts and only have to deal with paying back the principle loan amount. By streamlining your payments into one account, you also make payment easier on your part and, if they are on time, would even help in boosting your credit score. Most 0% interest cards have an 18-month introductory period which should give you enough time to pay all your debts.

2. Doing Several One-Time Purchases

Alternatively, a 0% interest card can help you deal with one-time purchases such as airline tickets or appliances. The introductory period for these cards allow you to stretch your payments over a considerable period of time. Since there is no interest for such payments, you need not worry about extra charges for each purchase.

3. Preparing for the Holiday Rush

Undoubtedly, it’s during major holidays that we often incur the most debt on our credit cards. Seasons like Christmas always feature cardholders maxing out on their available credit and having to deal with huge amounts of debt plus interest which takes a good portion of the next year to pay.

A 0% interest card can make holiday payments easier for you by removing interest altogether. Plus, some 0% APR cards feature some rewards and perks available for holidays, encouraging you to use the card provided, of course, you do so well within your credit limit.

4. Emergencies

There are also instances when you’d have to spend on necessities you didn’t plan for. For example, a huge tree fell on your roof and the insurance company, for some reason, won’t cover the damages. Or how about you get stuck in the middle of a foreign country due to miscommunication with your travel agency? Such events require you to use your credit card for paying medical bills and other services and, in these instances, having a 0% APR card can be advantageous for you.

The trick here is to not only look for a card with a low interest rate or none at all but also one with a credit limit high enough to accommodate huge, one-time emergency payments. This way, you don’t have to deal with huge interest charges as soon as you can get back to your feet.

Better Credit, Better Options

Generally, having a better credit score allows you to enjoy lowered APRs. In fact, the better your credit score is, the more alternatives you have in dealing with monthly interest rates.

As far as 0% APR cards are concerned, there are several things you have to consider:

• Introductory Period – This is period of time when the card does not accrue any credit. This can range from half a year to 18 months depending on the terms of the card. The best we have currently seen is the Sainsbury’s card with 29 months.
•  Balance Transfer Charges – This is basically the processing fees for transferring one debt from your account to another. Depending on the card, that could be around 2% to 5% of the amount you owe.
•  Annual Fees – Since it’s still a credit card, a 0% APR credit card will require annual fees to maintain. This could range from £50.00 to £200.00.
•  Annual Percentage Rate – Although the name says it’s 0% APR, that benefit lasts only as long as the introductory period. Once the period expires, you will have to deal with regular APRs which will be determined by your credit history and other factors.

If you have poor or near-average credit scores, you’d notice that the number of 0% APR options made available for you are limited. By improving your credit score, you can open yourself up to more options on dealing with interest with fewer downsides.

In Conclusion

Interest is an inescapable factor when you have credit. After all, your creditors would still have to find ways to earn from their transaction with you while also subtly prodding you to deal with your obligations to the best of your ability.

However, if you can maintain a history of good credit transactions, you’d find that there are more options given to you to lower your APR or, at the most, not have to deal with it for a good year or two. The point is that the faster you can pay your debts, the less damage the interest that debt has can inflict on you.

What other ways do you know of to deal with high interest rates? Is there any downside to a 0% interest card that you might know off? The comments section is open for all kinds of discussions and opinions.