Lenders will usually advertise an annual interest rate, but not all charge their interest annually. Some will calculate the interest monthly and others will calculate it daily. In this blog we will look at how the period of interest affects the actual amount of interest you pay.
Let’s look at three different people.
·There are three people, let’s call them Olivia, Jack and Lilly.
·Each person spends £1,000 on their credit card.
·All the credit cards have interest rates of 19%.
·All the people wait a year before making any payments (to make things simple we will ignore the fact that credit cards will have minimum repayments)
·Olivia’s card charges interest annually.
·Jack’s card charges interest monthly.
·Lilly’s card charges interest daily.
How much does Olivia pay?
This is the easiest. After a year she would have to pay back the £1000 bill and would then have to pay the interest. The interest would be£190 (£1,000 * 19%)
How much does Jack pay?
When interest is charged monthly, the monthly interest is calculated by dividing the annual interest by 12. In this case that would workout as a monthly interest rate of 1.57% (19% / 12 months).
After the first month there would be £15.83 interest (£1,000multiplied by 1.57% monthly interest). But this is not what is charged in all subsequent months.
Because Jack owes the credit card company this extra money it is added to his bill. He pays the interest on the full bill each month. In the second month the bill is £1,015.83. In the table below we show the balance each month and how much interest would be paid:
Jacks bill grows each month as the interest is added to it. Ashe pays interest on the balance the interest increases each month. Jack is paying interest on the interest. This is called compound interest.
Jack would pay back the £1,000 borrowed and £207.51 in interest.
How much interest does Lilly pay?
In the same way that the monthly interest is calculated by dividing the annual interest by twelve. Daily interest is calculated by dividing the annual interest by 365. This means Lilly has a daily interest rate of 0.052% (19% / 365 days). In the same way Jacks interest was calculated monthly, Lilly’s would be calculated daily. The following tables shows the first and last few days:
Lilly’s interest also compounds. But compounds more frequently. This means Lilly would pay back the £1,000 borrowed and £211.20 in interest.
Loans with the same interest rate can be more and less expensive
All the credit cards advertised the same annual interest rate, but the actual amount of interest paid differed.
You can calculate the effective annual interest rate they paid by dividing the interest paid by the amount borrowed:
Therefore, lenders have to advertise the APR of a loan or credit card. APR considers the total cost of borrowing the money and not just the headline interest rate. See our blog on Understanding Interest Rates and APR for more details.
