Compounding interest is often referred to as the “eighth wonder of the world,” and for good reason. Thanks to compound interest, a relatively small amount of money can grow into a large amount of money rather quickly.
The concept of compound interest is relatively straightforward. Simply stated, compound interest is when previous interest earns interest. For example, say you have $1,000 that earns 5% interest each day. On day one you would earn $50 interest on that $1,000. On day two you would earn $52.50 interest on the new balance of $1,050. On day three you would earn $55.125 on the new balance of $1,102.50, and so on. The amount of earned interest continues to increase because the previous earned interest is added to the balance.
Compound interest is neither inherently good nor bad and how it affects you depends on the situation. When you have money invested in an interest-bearing savings account, compound interest works to your benefit by allowing you to grow your balance more quickly. When you have credit card debt, however, compound interest charges work against you by making it more difficult and costly to pay off balances.
Most credit card offers are quoted using an annual percentage rate (APR). However, this rate can be somewhat misleading. Interest is compounded on most credit cards either daily or monthly. When compounding is taken into consideration, the annual percentage rate is expressed as the effective annual rate (EAR). The calculation for EAR is EAR=(1+APR/n)n-1 where “n” equals the number of compounding period. For example, for a credit card with a 14% interest rate that compounds monthly, the one year EAR would be (1+.14/12)12 –1, or 14.93%. Compounded daily, the one year EAR is (1+.14/365)365 –1 or 15.02%. Because most U.S. credit cards compound interest daily, knowing the EAR is important to comparing credit cards with different compounding practices and understanding the true cost of
If you pay off your credit card quickly, compounding interest may not cost you very much. Where compound interest can really be problematic is if you carry a balance on your credit card and only pay the minimum payment. The minimum payment is typically calculated as a percentage of the outstanding balance, usually 2%. Your minimum payment goes towards paying off your interest charges before paying of the principal. Consequently you are paying down your balance much slower.
For example, if you have a 10,000 balance on a credit card with a 14% interest rate that is compounded monthly, you would be charged a periodic interest rate of about 1.1667% (14%/12 months). That would be $116.67 in finance charges the first month alone. From a $200 minimum payment (2% of $10,000), only $83.33 would be applied to the principal. The next month, your balance would be $9,916.67, which would incur $115.69 in interest charges. Your minimum payment would be $198.33, of which only $82.64 would go towards the principal. At this rate, it would take over 36 years to pay off the original balance assuming no additional charges were added, and only the minimum payments were made.
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