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Why are credit card interest rates so high?

Why are credit card interest rates so high?
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Shocked at the high interest rate payable on your credit card? You’re not alone.

While credit cards are becoming increasingly popular, they continue to be a relatively expensive way to borrow money. When compared with mortgages or personal loans, which have annual interest rates of just a few per cent in many cases, annual credit card interest rates are often well into the double digits.

Here I explain how lenders justify high credit card interest rates and I suggest how it might be possible to reduce the interest paid on credit card debt.

Why so high?

Whenever a lender decides what interest rate to charge a borrower, its key consideration is the risk of its money not being paid back. With a mortgage or a personal loan for a car, for example, there are assets against which the loan can be secured. As such, if a borrower fails to repay the loan, the lender can repossess the asset, sell it and reclaim some if not all of the money owed.

With a credit card, though, the debt is unsecured: there is no asset for the lender to repossess if the borrower fails to make repayments. This can mean that the lender (in this case, the credit card company) fails to recoup the debt in a greater number of situations than is the case for a secured loan.

A lender also does not ask a borrower what a credit card will be used for. While most people use their credit cards for everyday items such as food or clothing, a credit card holder could equally use the card for more speculative purposes such as gambling. As a result, the higher potential for financial mismanagement and subsequent default must be factored in by a credit card issuer.

Reducing interest payments

The good news is that individuals can take various steps to reduce the interest they pay on credit card debt.

Credit card companies generally offer the best interest rates to consumers who have the highest credit scores. A good place to start may therefore be to obtain a free credit report and then take action to improve a credit score, for example by ensuring existing loan repayments are up to date.

Consumers with existing credit card debt may also want to consider a balance transfer credit card. Such cards may offer a lower rate of interest than that being paid on a current credit card. A balance transfer can significantly reduce total interest payments during the balance transfer period. For example, an individual with a £2,500 balance paying an APR of 18.9% who repays £100 per month could save £629 by obtaining a 0% balance transfer card. Although there may be a balance transfer fee to consider, the fee is generally less than the interest saved during the balance transfer period.

It may also be possible to take out a personal loan to repay credit card debt. A lender may require security in order to do so, but the interest payments on a personal loan may be significantly lower than those on a credit card. A variety of eligibility checkers are available, so it may be possible to find out the chance of being approved for a personal loan without conducting a full credit check, which may help preserve an individual’s credit score.

My verdict

Borrowing on a credit card is expensive relative to other forms of loan such as mortgages or car loans. However, my suggestions above may go some way to helping individuals reduce the amount of interest they pay on existing credit card debt.

Of course, some credit card debt may be unavoidable. Going right back to basics, it may be prudent to consider whether purchases are really necessary before adding to total debt. Through a budgeting and savings plan, it may be possible to reduce overall debt in the long run and even end interest payments altogether.

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