Credit Cards How Credit Cards Work

Most people nowadays have at least one credit card to their name. They are a hugely popular way of paying for goods and are also a safe way of paying for things on the Internet as you are protected from fraud. Despite the recent global recession they are now fundamental to our way of living and shopping. However, many people do not know or understand exactly how they work.

A credit card gives you an initial period (around 59 days) whereby you can purchase something without having to pay for it (i.e. you get credit). Consider this a type of loan that a card provider is giving you. After that initial period you need to pay for your purchase (i.e. pay the loan back to the company).

If you pay for your purchase (or loan) in full then you will not be charged interest. If you only pay back the minimum amount (typically 5% or a set minimum ~?5) then the card provider is entitled to charge you interest on that outstanding amount (i.e. the loan). The amount of interest you get charged depends on the terms but can typically be around 16% APR.

This 16% APR is added to outstanding amount (i.e. loan) so that the outstanding amount increases by the time of your next statement, even if you have not purchased anything else using your credit card. If you continue only paying the minimum amount (i.e. 5%) you will continue to be charged the 16% APR on the outstanding amount.

Note: APR (Annual Percentage Rate) is an annual rate. However, due to compound interest you can’t quite divide it by 12 to get the actual monthly amount although it is usually quite close.

The best way to illustrate the above is through an example:

Assume you have a card that gives you an initial period of 1 month credit and a 16% APR (for the purposes of this calculation we will assume 16%APR equals 1.33% per month – i.e. 16% / 12 months = 1.33%). At the start of the month you purchase something at a cost of ?200.

You do not pay anything until the end of the month when you receive your statement with an outstanding amount (i.e. loan or balance) of ?200.

You pay the minimum amount of 5% of ?200, which is ?10.

Your outstanding amount (i.e. loan) is now ?190. However, as you only paid off the minimum amount the card provider charges you interest of 16%APR on that outstanding amount (i.e. loan).

16%APR (i.e. 1.33% per month) of ?190 is ?2.53 so the new outstanding amount is ?192.53.

You do not purchase anything else on your card and at the end of the next month you receive your statement, which now has the outstanding amount of ?192.53. Again you pay the minimum amount of 5% of ?192.53, which is ?9.63

Your outstanding amount (i.e. loan) is now ?182.90. However, as you only paid off the minimum amount the provider charges you interest of 16%APR on that outstanding amount (i.e. loan).

16%APR (i.e. 1.33% per month) of ?182.90 is ?2.43 so the new outstanding amount is ?185.33.

And so on until the outstanding amount is paid off. As a guide, based on the above, it would take around 42 months to pay of the debt and you would pay back in the region of ?250.

From the above example you can see that a purchase of ?200 ends up costing you around ?250 because you bought it on credit and did not pay off the full amount at the end of the month. If you had paid of the full amount you would not be charged any interest and would pay back the ?200 only. The table below shows the above calculation in action.

In essence that is how credit cards work. They simply give you a interest free loan for a period before charging you very high interest rates unless you pay off the full loan amount as and when due. The differences between individual cards come down to such things as the different interest rates that are charged, the length of interest free periods, fees and so on.

Hopefully this article has given you and idea of how credit cards work so you can chhose the top credit cards for your needs.

Ben graduated with a business and economics degree back in 1998. Following many years service in the financial sectors Ben has turned his attention to helping everyday people with their finances. He has seen first hand how many people struggle with their financial situation primarily due to poor advice and misunderstandings of how money works. His latest venture is a blog that allows users to compare credit card rates in the UK.

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