Compounding Interest: A Force of Good and Evil
Einstein put it best when he said, “Compounding interest is the greatest mathematical discovery of all time”. Now the question you need to ask is, “Do I want this force working for me or against me?” If you own a credit card and you carry-over balances from month to month then you’ve got that amazing force called compounding interest working against you.
In this article, I’ll attempt to explain how this “force” works against you month after month after month, in the form of interest upon interest. You will gain a better understanding of how this “force” works and how important even a small change in the interest rate you are being charged effects you and family’s financial future. Hopefully, it will also inspire and motivate you to do whatever it takes to pay off your credit cards and initiate some type of savings plan so you can put this “force” to work for you.
Credit Card Interest Rates are Compounded
The interest you pay on your credit card balances are compounded, which means that you pay interest on the interest from the month before. A simple example would be that if you were being charged an interest rate of 2% per month, you would not be paying 24% per year. In reality, you would be paying 26.82%. A neat little trick that credit card companies use to pick up an additional point or two of interest is to calculate interest on a monthly rather than on a yearly basis. You pay more but you don’t know you’re paying more.
A Brain Teaser
Here’s a little brain teaser. Would you rather have $1 million in cash or $10,000 in some form of savings account earning you a compounded interest rate of 20 percent per year?
Hmm, let’s see how that $10,000 would grow. The following chart assumes an initial acount deposit of $10,000 with no withdraws.
|Number of Years
|Total account balance
After fifty years, you would have over $500 million. Not a bad return on your investment of $10,000!
Clearly, that question was a bit tricky because there’s so many variables to take into account that would influence what decision you would ultimately make. Now you can see the power of compounding interest. It’s the primary way credit card companies make their money.. It’s also the way pensions work and the reason the prices of things seem to rise massively as you get older. Be afraid, or at the least very wary, of compounding interest.
Compounding Interest Can Really Add Up
Now, let’s look at a more real world example. Let’s say you have an average unpaid balance of $1,000 on a credit card with an APR of 15 percent.
First year interest would be $150. However, this amount is then carried-over and added onto the balance and interest is charged on that. As a result, year two interest would be another $172.50 for a total of $1322.50 and it continues to build year after year. Year three, four and five would look like this – $1,520, $1,749 and $2,011.
As you can clearly see, after just five years at 15%, you would owe double what you borrowed and after 10 years you would owe four times. I know it’s hard to believe but once again this simple “real world” example dramatically demonstrates the power of compounding interest.
If you let something like that carry on long enough, you end up paying on that same amount of debt for years and years. You end up paying back many times what you originally borrowed and in some instances you still may not have completely satisfied the original debt. Unfortunately, most people simply don’t take the time to think through this. They feel that the high and never ending payments are simply their fault for spending too much money to begin with.
The Three Percent Difference
You may feel that there’s not that much difference between a credit card that charges an APR of 15% versus one that charges an APR of 12%. Remember the previous example that showed you would owe over $2,000 after only five years at 15% after borrowing an initial amount of $1,000?
That same example at 12% reveals the following: Year one – $1120, year two – $1254, and years three through five – $1404, $1573 and $1762 respectively. After the same five year period you would have saved nearly $250 or almost 25% in interest from a mere 3% difference in APR. Quite dramatic and hopefully it will help you convince you to make the necessary decisions to pay off your credit cards and start saving. You can put, “the greatest mathematical discovery of all time” to work for you rather than against you.