Compounding interest has a fierce effect on the cost of letting your credit card balance roll over each month, boosting sky-high rates even higher

By David Chaston

Can't pay your full credit card balance this month? Then you will know that the main banks will charge you interest at about the rate of 20.95% per annum for the ability to delay your payment.

Actually, there is a range of rates on offer from a low of 12.95% pa (the Co-operative Bank Fair Rate Mastercard plan) to 25.99% pa (at Gem Visa).

By now you will know that these rates are very high, and on top of them, there is the annual fee. And if you use your credit card to make a cash withdrawal, the rates are higher still.

But what you probably don't know is that these rates are declared on an "annual percentage rate" basis. If you use the delayed payment option every month, the effective annual percentage yield is even higher.

And that is because there will be interest on interest. Interest is charged every month and debited to your account. That forms part of your next month's opening balance on which the next month's interest is based.

In reality, that means your dollar interest cost could be more than 10% higher than you might otherwise think. For a "12.95%" rate, the effective rate is 13.79% (an 84 basis points or 6.5% premium). For the "25.99%" rate, the effective rate is 29.41% (a +342 bps or 13% premium).

Here is an element of our online credit card interest rate table with the effective cost of not paying your balance off over any month in a year added:

Visa Issuer	Plan	Interest free period	Fee primary $	Balance transfer %	Balance transfer period	Cash Adv %	Purchase %	effective % cost
						APR	APR	yield
ANZ	Low Rate	55	35.00	1.99	12 mths	20.95	13.90	14.87
	Airpoints Visa	44	65.00			20.95	20.95	23.15
	Airpoints Visa Platinum	44	150.00			20.95	20.95	23.15
	CashBack	55	60.00			20.95	20.95	23.15
	CashBack Platinum	55	125.00			22.95	20.95	23.15
	Visa Light	55	0.00	0.00	6 mths	22.95	13.50	14.41
	Rewards	55	40.00	0.00	6 mths	22.95	20.95	23.15
	Gold	55	80.00	0.00	6 mths	22.95	20.95	23.15
	Platinum	55	80.00	0.00	6 mths	22.95	19.95	21.95
BNZ	Advantage Classic	55	40.00	0.00	6 mths	22.95	20.95	23.15
	Advantage Visa Platinum	55	90.00	0.00	6 mths	18.95	18.95	20.75
GEM Visa	Gem Visa (<$250.00)	55	52.00			25.99	25.99	29.41
	Gem Visa (>$250.00)	180	52.00			25.99	25.99	29.41
SBS Bank	SBS Visa	55	0.00			21.50	18.50	20.21
The Warehouse	Purple Visa	55	0.00			22.95	19.95	21.95
	Warehose Money	55	0.00			22.95	19.95	21.95
TSB Bank	Standard	55	30.00			18.50	18.50	20.21
Warehouse Money	Warehouse Money	55	0.00			22.95	19.95	23.15

The effective cost of debt would be even higher if we included the annual fee.

It is true that if you incur interest for just one month, the rate charged is also the effective rate. But if you let it slide, you are boosting the bank's interest earnings, from you, for every month you do that.

The maths is straightforward. What you might assume is the formula, namely: [ APR = periodic rate × number of periods in a year ] isn't what is used. What is actually used is the more accurate one for compounding interest, namely [ APR =(1+periodic rate) ^∧ number of periods −1 ].

The power of compounding interest works well for bank earnings. You may think you are paying an eye-watering 20.95% pa rate but in fact if you don't pay off that debt within one month and let it drag for a year it could be 23.15% in a year. Or more.

*Also see; Why the regulators should take a look at the credit card market.

*This article was first published in our email for paying subscribers early on Thursday morning. See here for more details and how to subscribe.