Credit cards charge high rates of interest and are an especially expensive form of borrowing or debt. However, they are a good way to build your credit score, if managed correctly. If you clear the credit card balance monthly you won’t pay any interest. If you don’t, the balance attracts interest on a compounding basis. Compound interest is interest charged on interest. It is important to understand the effect of compounding interest, click on the link below to learn more:

Credit cards, compound interest and payments

To illustrate the impact of compound interest, assume an outstanding credit card balance of £1,000. With an interest rate of 17%, the monthly repayments are £25, or £300 for the year. From the £300 annual payment, £159 will be interest and a miserly £141 will go towards paying off the balance of £1,000, leaving an outstanding balance of £859. It speaks for itself, not great value with 53% of the payments swallowed up in interest over the year. In this example, it will take 5 years to pay off the debt of £1,000, incurring £484 in interest charges.

This example assumes interest is compounded monthly, whereas it is likely to be compounded daily, adding to the interest charge. Credit card companies want you to pay the minimum repayment balance, as this allows them to maximise the amount of interest they can charge you. This keeps you indebted to them for as long as possible. To avoid falling foul of this:

• Try to avoid having a credit card.
• Pay off the balance in FULL every month to avoid interest charges.
• Pay more than the minimum payment, if you are unable to pay off the balance in full.
• Move the balance of a credit card to another credit card provider that is offering a lower rate of interest. Some credit card providers will allow you to transfer an existing balance to them and receive an interest-free period, often of around 6 months.

Credit score and rating

Your build your credit score and rating over time which shows how well you repay money taken on credit. A high credit rating means you are a low-risk borrower, repaying your debt on time. The higher your credit rating, the easier you will be able to access credit and borrow money, at more competitive interest rates. A good credit rating can also determine the rate of interest a credit card company will charge you.

APR and AER

Interest rates are often expressed as APR and AER. APR is the annual percentage rate of interest for debt. AER is the annual equivalent rate of interest on savings accounts. The APR and AER allow you to compare the interest rates on loans, credit cards and savings.

APR includes the interest charged on the actual loan amount plus other compulsory charges, such as annual fees. APR can be a representative figure and a lender must provide this rate of interest to at least 51% of credit applicants. The other 49% of applicants may pay a higher rate of interest, which is where having a good credit score is beneficial. Your personal APR is the rate of interest you pay.