Two loans quoting the same rate can cost different amounts. The difference lies in how interest is calculated and when it is applied, which is specified in the agreement and almost never in the advertising.
Simple versus compound
Simple interest accrues on the original principal only. Compound interest accrues on principal plus accumulated interest.
Over short periods the difference is small. Over long periods it is the whole story.
Most consumer credit compounds, and the frequency of compounding — daily, monthly, annually — changes the effective cost even at an identical stated rate.
Nominal rate against effective rate
The stated annual rate is generally nominal, meaning it does not account for compounding within the year.
The effective annual rate does, and it is always higher when compounding occurs more than once a year.
Regulations in most markets require disclosure of a standardised comparison figure precisely so that products can be compared, and that figure is the one worth reading.
It also typically incorporates mandatory fees, which the headline rate does not.
Daily accrual on cards
Credit cards generally accrue interest daily on the outstanding balance.
Which means the timing of payments within a cycle affects the cost, not just the amount.
It also means a partial payment reduces the balance on which interest accrues from that day forward, so paying earlier in a cycle costs less than paying the same amount later.
The grace period and how it is lost
Most cards offer an interest-free period on purchases if the statement balance is paid in full by the due date.
Pay in full and purchases cost nothing in interest. This is the arrangement most people believe they have.
Carry any balance, and on most cards the grace period is lost until the balance is cleared in full again — meaning new purchases begin accruing interest immediately.
Which is why the transition from paying in full to carrying a balance costs more than the interest on the carried amount alone.
Payment allocation
Where a card carries balances at different rates — purchases, cash advances, a promotional transfer — the order in which payments are applied matters enormously.
Historically, allocation to the lowest-rate balance first was common, which kept the expensive balance outstanding.
Regulation in several markets now requires payments above the minimum to be allocated to the highest-rate balance first.
Payments at or below the minimum are frequently still allocated at the issuer's discretion, which is worth knowing.
Amortisation on instalment loans
A fixed-payment loan applies each payment partly to interest and partly to principal, with the split changing over the term.
Early payments are mostly interest. Later payments are mostly principal.
Which means the balance falls slowly at first, and someone selling a car three years into a five-year loan frequently owes more than they expected.
Requesting an amortisation schedule at the outset makes this visible, and lenders will provide one.
Overpayment mechanics
An overpayment can reduce the term or reduce the payment, and which one happens depends on the agreement and sometimes on an instruction you must give.
Reducing the term saves considerably more interest. Reducing the payment improves cash flow.
Lenders do not always apply the more beneficial option by default, and asking explicitly is worth doing.
Early repayment charges, where they exist, are disclosed and are frequently structured to fall over the term.
Minimum payments
The minimum on revolving credit is generally a small percentage of the balance with a floor.
Paying only the minimum on a substantial balance extends repayment over a period measured in years or decades, with total interest frequently exceeding the original balance.
Statements in many markets are now required to show this explicitly, and the figures are startling enough that the disclosure requirement was clearly justified.
Why any of this matters
Because the decisions that follow — which balance to pay first, whether to consolidate, whether overpaying is worthwhile — depend on the mechanics rather than on general principles.
Two people with superficially identical debts can have quite different optimal actions depending on how their agreements calculate interest.
The agreements are legally required to disclose this, and reading them is the only reliable way to know.
Nothing here is advice about any individual situation. Anyone in difficulty with debt should be talking to a free regulated debt advice service, which exists in most countries and is considerably better than anything found in an article.
Variable rates and what they track
A distinction worth making since the mechanics differ.
Some variable rates are contractually linked to a published reference rate plus a fixed margin, which means the movement is mechanical and predictable.
Others are set at the lender's discretion, with the agreement specifying only that the lender may vary the rate on notice.
The first moves with the reference. The second moves when the lender decides, which historically has meant quickly upward and slowly downward.
Which of these applies is stated in the agreement and is one of the more useful things to know before signing.
Default interest and fees
Agreements typically specify a higher rate applying after default, plus fees for missed payments and for exceeding limits.
These compound the problem they respond to, which is why regulators in several markets have capped them.
Where caps exist they are frequently expressed as a total cost limit — the total repayable may not exceed some multiple of the amount borrowed — which is a blunter instrument than a rate cap and harder to circumvent.