The APR Formula
The calculation of APR is complex and regulated by the FCA, but the core mathematical principle relies on the effective interest rate formula, which accounts for compounding:
Where r is the nominal interest rate (including fees) and n is the number of compounding periods per year. You do not need to do this math yourself — lenders must provide the final APR figure — but understanding that it accounts for compounding is vital.
What Fees Are Included?
To calculate the APR, the lender must take the base interest rate and add any mandatory fees required to obtain the credit. This typically includes:
- Annual or monthly card maintenance fees
- Loan arrangement or setup fees
- Mandatory insurance premiums (if required as a condition of the loan)
This is why a credit card with a 15% interest rate and a £100 annual fee will have a much higher APR than a card with a 15% interest rate and no fee.
Daily Interest and Compounding
A common misconception is that a 24% APR means you are charged 2% interest per month (24 divided by 12). This is incorrect.
Credit card interest accrues every single day on your unpaid balance. The daily rate is roughly the APR divided by 365. If you have a £1,000 balance at 22.9% APR, you are charged approximately £0.63 in interest every day.
At the end of the month, that accrued interest is added to your balance. The next month, you are charged interest on the new, higher balance (the original £1,000 plus the interest). This is compound interest — paying interest on interest. The APR figure accounts for this compounding effect, which is why it is always higher than the simple nominal rate.
Action Step
Because interest accrues daily, paying your credit card bill earlier in the month — even a few days before the due date — reduces the total amount of interest you are charged.