How credit card interest actually works

You probably already know that credit card interest is expensive. But the mechanics of how it is actually calculated and applied are not always obvious, and the gap between the headline rate and what you end up paying in practice can be significant.

What APR means

APR stands for Annual Percentage Rate. It is the cost of borrowing expressed as a yearly percentage and includes fees as well as interest, which makes it a more honest comparison figure than a raw interest rate. If a card has a 29.9% APR, that is the approximate annual cost of borrowing on it.

However, interest on credit cards is calculated daily rather than annually. The daily rate is the APR divided by 365. On a 29.9% card, that is roughly 0.082% per day. It sounds tiny. Multiplied across a month and applied to a balance that has not been paid off, it adds up faster than most people expect.

How the interest appears on your statement

Each month you get a statement showing your balance, the minimum payment due, and an interest charge if you carried a balance from the previous month. The interest is calculated on your average daily balance during that billing period, multiplied by the daily rate, multiplied by the number of days in the period.

If you pay your full balance by the due date every month, you pay no interest at all. Credit cards effectively give you free credit for up to 56 days if you pay in full and on time. The cost only starts if you carry a balance forward.

The minimum payment trap

Minimum payments are usually set at around 1 to 3 percent of your balance, or £25, whichever is higher. They are designed to keep the account in good standing, not to pay the debt off in any reasonable timeframe. If you have a £3,000 balance on a 29.9% card and pay only the minimum each month, you could be paying it off for well over ten years and paying more in interest than the original debt.

Your statement is now legally required to show you how long it will take to clear your balance if you make only minimum payments, and how much that will cost in total. It is worth reading that line carefully.

What to do if you are carrying a balance

The most impactful thing you can do is pay more than the minimum every month, even if only a little more. Every extra pound reduces the balance on which interest is calculated the following day. Over time, even modest overpayments reduce the total interest paid and shorten the repayment period significantly.

If you have multiple credit cards with different rates, paying off the highest-rate card first (while making minimum payments on the others) saves the most money overall. This is the avalanche method of debt repayment.