Many people who take out a credit card will “promise” themselves that they will pay the outstanding balance at the end of each month. Consequently, many of us perhaps don’t pay as much attention to credit card interest rates as we should. Do credit card interest rates matter? Of course they do. However, not understanding how credit cards work could leave you with significant interest charges and long-term debt.
As with any financial instrument, if you respect your credit card and use it wisely, it can be beneficial and not overly expensive. However, if you start to depend on your credit card, this is where problems can begin to emerge.
When looking at credit card interest rates, you will come across the term Annual Percentage Rate (APR), which differs from the flat interest rate. Due to several regulatory changes introduced by the Financial Conduct Authority (FCA), the APR is more representative of the underlying costs associated with a credit card. Consequently, credit card companies are now legally obliged to quote the APR. So how is the APR different to the flat rate?
The APR includes additional costs that you would expect to incur under normal circumstances. The most obvious fee is an annual charge credit card companies add to your account every 12 months. When you see APR figures, it is important to note these relate to a theoretical balance of £1,200 for illustration purposes.
The following calculation demonstrates how credit card providers calculate APR:
Flat interest rates: 20%
Credit card balance: £1,200
Annual charge: £50
Total balance: £1,250
The 20% interest rate equates to £250 a year based on a £1,250 credit card balance, including the annual charge. To calculate the APR, express £250 as a percentage of the original £1,200 credit card balance. This equates to the following:
APR: £250/£1,200 expressed as a percentage = 20.83%
So the flat rate is 20%, but the APR is 20.83%. While this may not seem like a huge difference, this is effectively the real interest rate you will pay.
Before we look at how providers calculate interest on your credit card balance, we must note the different rates on the same credit card, applicable to separate transactions.
The APR quoted by credit card companies relates to the purchase rate when using a credit card to make card purchases of products and services.
Competition is intense within the credit card industry. As a result, many companies will offer either reduced rates or a period of zero interest on balances transferred from competitors. This rate can be significantly less than the purchase rate.
When using credit cards as quasi-cash (money transfers), you will be charged a premium on the purchase APR rate.
Similarly to the money transfer rate, the cash transaction interest rate will be at a premium to the purchase APR. This relates to withdrawing cash from an ATM using your credit card.
Regarding credit card interest rates, regulations deem that at least 51% of those who successfully apply for a credit card must get the representative APR rate (the published rate). As a result, up to 49% of customers will see their successful application confirmed with a higher APR.
Credit card fees
Customers who repay their balance in full monthly are not those that credit card companies prefer. Therefore, while there may be the opportunity to cross-sell different products and charge an annual fee, the scope for profit could be much higher. However, you should be aware of additional costs and charges you may face in different circumstances, whatever your situation.
For example, the Royal Bank of Scotland currently charges:
- A 2.75% fee for foreign transactions
- An additional 3% for cash advances
- A fee of £12 every time you miss your repayment due date
- A fee of £12 if you exceed your credit limit
- Returned payment fees of £10
As of early 2023, the Royal Bank of Scotland is not charging an annual fee, although this could change. Customers also need to be aware that credit card companies can adjust the interest rate on your account for any reason, but they will need to give you a minimum of 45 days’ notice.
When you see a credit card rate of interest described as the APR, this assumes a one-off payment at the end of every year. In reality, credit card companies will charge you interest every day on outstanding balances. The cumulative effect of interest on interest will further increase the real interest rate you pay. We call this the Annual Percentage Yield (APY).
The base figure for this calculation is the APR, which in this instance, is 20.83%. The below highlights the impact of interest on interest charged over different periods:
Annually: APY 20.83%
Monthly: APY 22.94%
Weekly: APY 23.11%
Daily: APY 23.15%
UK credit card companies charge interest daily but only add it to your account at the end of each month. There are no interest charges if you pay the outstanding balance in full. So, we have gone from a flat rate of 20% to an APR of 20.83% and finally an APY of 23.15%
What factors impact credit card interest rates?
Back in the credit card heyday of the 1980s, it was effortless for many people to apply for a credit card successfully. They were often relatively young and on a limited income! At the time, house prices were rising, and stock markets were touching all-time highs; it seemed like a never-ending dream. However, fast forward to the US mortgage crisis of 2008, and the worldwide economy received a short sharp shock that it is still feeling more than a decade later.
The subsequent global credit crunch led to a clamping down on unaffordable finance, with eligibility now calculated using strict criteria. Some of the factors that will impact your credit card application include the following:
- Financial history
- Credit rating/credit score
As noted above, only 51% of successful credit card applicants are legally entitled to the representative APR. As a result, credit card companies have the scope to accept applications but charge a higher rate based on the above factors and any other relevant information.
Balance transfer credit cards
We already mentioned using balance transfers to reduce the interest you pay. Still, there is more to consider than just interest rates. A balance transfer to an introductory rate can be an advantageous means of addressing relatively high debt levels. However, there are numerous pros and cons to consider.
When looking at the array of available balance transfer offers, it is essential to look at the introductory rate AND the duration of the low-interest/interest-free period. A low headline APR will likely attract your attention, but sometimes a slightly higher APR with a longer term may be more appropriate.
You must complete the application process to arrange a balance transfer to a new credit card. Consequently, before completing the balance transfer, you will already know the APR on new purchases, money transfers, and cash withdrawals. Do you feel you’re getting a fair deal? Does the rate reflect your financial situation and credit score? Are there any better deals out there?
When looking at a balance transfer, many assume their new credit card company will automatically allow a complete balance transfer of their outstanding third-party debt. This is not the case. The maximum balance transfer allowed would be dictated by the credit limit you receive when applying for your new credit card. In some cases, you may not be able to transfer your entire outstanding balance.
Historically, many credit card companies offered 0% interest (or an extremely low rate) on balance transfers with no additional charges. Nowadays, credit card companies tend to charge a balance transfer fee, which averages around 3% of the transfer balance, although it can be higher. While often seen as a stand-alone fee, you should consider it alongside the outstanding balance and the promotional balance transfer rate.
Promotional credit card rate of interest
As wholesale lenders, credit card companies have been able to utilise the relatively low cost of borrowing. However, Bank of England base rates are rising. Consequently, many credit card companies can offer attractive promotional rates to attract new customers. If you come across a promotional period or rate that catches your eye, it is crucial to look at the finer detail.
The representative APR may not apply to you, and your actual rate could be relatively high. In addition, as we touched on above, while historically, balance transfers were free of additional charges, this is not the case today. Therefore, comparing and contrasting all factors associated with a promotional credit card offer is essential.
Many people forget the basics, often blinded by the introductory offer; what is the representative APR compared to competitors? In hindsight, these factors seem obvious, but you must be on your guard.
Since the US mortgage crisis of 2008, and the more recent Covid pandemic, regulators have adopted a stricter approach to applications for finance. This was perhaps most visible with the now discarded mortgage affordability test in the home finance industry. There are also strict criteria for credit card applications. The key to the ongoing changes is the protection of consumers and the integrity of markets.
The Financial Conduct Authority (FCA) regulates credit card providers as part of the broader financial services industry. However, there are several other bodies involved in the credit card industry.
The Payment Systems Regulator (PSR) is a subsidiary of the FCA, which came into effect on 1 April 2015. The objectives of this regulator are simple, to encourage and promote innovation and competition within the payment systems industry. However, this must be carried out within a framework that protects the interests of those using UK payment services.
The Lending Standards Board (LSB) is a voluntary, industry-recognised body ensuring that companies provide a fair deal for personal customers. The LSB sets the benchmark for “good lending practice” across various financial products, including credit cards, loans, and bank accounts – current accounts and overdrafts.
Will a credit card balance transfer impact your credit rating?
Transferring funds from one credit card to another will not directly impact your credit rating. If anything, the transfer to a lower interest rate is a positive step in maintaining and increasing your credit rating. That said, it is common knowledge that multiple financial applications will appear on your credit rating and can have a detrimental impact. The key is to be selective and focused, ensuring you get the best deal for your situation as soon as possible.
There is a general misconception that a joint credit card means that liabilities are split between the parties. In reality, there is no such thing as a joint credit card in the UK. By all means, you can add approved parties to your credit card account, but you will still be liable for all debts associated with the account.
Research shows that credit card debt is one of the most expensive forms of finance if you fail to pay off your balance in full each month due to the interest charged. In addition, cash advance and withdrawal fees, foreign currency, transaction fees, and late payment penalties can be hefty. If your credit card balance is getting out of control, it may be worth approaching a financial adviser to discuss a plan of action.
As with any debt, it is better to be proactive rather than reactive if you foresee future difficulties with monthly payments. You may have the option of consolidating debts, arranging a payment plan with your credit card company, or simply reducing your credit card expenditure. The closure of your credit card account and a more structured approach to your financial troubles can quickly begin to pay dividends.
Credit card interest rates can dictate your financial well-being
While most people will take out their first credit card with the intention of clearing the balance at the end of each month, this can be challenging. While individuals have the best intentions, pressure can begin to build very quickly. You end up spending your wages and digging deep into your credit card limit. As the minimum payment level rises, many people receive a wake-up call.
As we have touched on above, there are numerous ways to reduce your immediate costs, such as balance transfers. However, whether looking at a balance transfer or an introductory offer APR, it is essential that cardholders don’t look at these issues in isolation but in their broader context. Consequently, many people prefer to take advice from their financial advisers to ensure they take the correct course of action for their scenario.