Credit Cards – How Interest Rates Work

Credit card providers advertise their cards primarily using interest rates. The use of interest rates enables a quick comparison of different credit cards to be done. Therefore, it is important to have at least a basic understanding of how interest rates work.

Consider interest rates as a thank you payment. If someone gives you £ 100 today for you to buy something. A week later you give them the £ 100 back plus £ 5 to say thank you for lending that money to you. Interest is exactly the same.

Interest is considered in terms of months and years, with interest usually being charged monthly. Taking the above example a bit further. Someone gives you £ 100. A month later you intend to give them the £ 100 back plus the £ 5 interest thank you payment. However, you do not repay them that month but instead wait till the next month. So the next month you give them back the £ 100 plus two lots of £ 5 (ie £ 10) as a thank you payment.

APR stands for Annual Percentage Rate and is simply an interest rate per year. This is the interest rate that you will be charged at (or the amount of thank you payment you will be entitled to pay) for your loan over the course of a year. It is expressed as a percentage of the loan amount. 1% equates to 1 divided by 100 multiplied by the loan amount; 6% equates to 6 divided by 100 multiplied by the loan amount. As it is an annual figure, to get the monthly figure you just divide it by 12.

So a 12% APR on £ 1000 means that if you borrow £ 1000, then after a year you pay back £ 1000 plus 12% of the £ 1000. 12% is 12 divided by 100, which equals 0.12. Multiply this by the loan amount (ie £ 1000) equals £ 120. After a year you will pay back £ 1000 plus £ 120 = £ 1120.

So far it has been very straightforward and the above interest is considered 'simple interest' as it is simply the loan value plus the interest percentage of the loan value. However, there is a slightly more complicated interest called 'compound interest'.

Compound interest is where the interest is added month on month to the loan value. Assume an APR of 12%. This equates to a monthly interest of 1%. So with a £ 1000 loan after one month you will be due to pay £ 1000 plus the 1% of £ 1000 which is £ 10 making the end of month loan amount £ 1010. At the end of month two you will be due to pay £ 1010 plus 1% of £ 1010 which is £ 10.10, making the end of month loan amount £ 1020.10. Over the period of a year the final end of year amount comes to £ 1126.83.

Because because of compound interest the final interest payment after a year is £ 126.83, compared to £ 120 with simple interest (ie £ 6.83 more). Credit cards use compound interest. So, with the addition of compound interest the resultant payment will be more than that for simple interest.

Hopefully the above has provided a basic explanation of how interest works. Knowing even this basic information will help you to compare credit card rates and choose the top credit cards for your purpose.

Source by Ben Gavin

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