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Credit Card Interest Rates – Why It’s Important To Understand How They Work

Einstein said it best, “Compound interest is the greatest mathematical discovery ever made”. Now the question you need to ask is, “Do I want this force to work for me or against me?” If you own a credit card and you roll over the balance every month, you’re experiencing an amazing thing called compound interest. The forces are against you.

In this article, I’ll try to explain how this “force” can work against you month after month in the form of interest plus interest. Perhaps, by helping you better understand how this “power” works and how much a small change in the interest rate you’re charged can matter to your and your family’s financial future. Hopefully it also motivates and motivates you to do whatever it takes to pay off your credit cards and start some type of savings plan so you can make that “power” work for you.

Credit Card Interest Rate Compounding

The interest you pay on your credit card balance is compounded, which means you pay interest on the previous month’s interest. A simple example is that if you pay 2% monthly, you don’t pay 24% annually. Effectively, you’ll pay 26.82%. A neat little trick that credit card companies use to earn an extra bit or two of interest is to calculate interest on a monthly rather than annual basis. You give more, but you don’t know you give more.

brain teaser

This is a little brain teaser based on what you’ve already learned. Would you rather have $1 million in cash or $10,000 in some form of savings account that earns 20% compounded annually?

Well, let’s see how that $10,000 grows in 10 years – $61,917 or 20 years – $383,375 or 30 years – $2,373,763 or 50 years – $563,475,143.

Fifty years from now, you’ll have over $500 million. Of course, you have to take inflation into account, and if we use a figure of 5% per annum, that $500 million would have the purchasing power of $10,732,859 today. Nice return on a $10,000 investment, but on a side note, it also reveals another lesson about how inflation destroys wealth, but that’s a topic for another post.

Obviously this one is a bit tricky because there are so many variables to consider that can affect the decision you end up making – but you get my point, the power of compound interest, by the way…it’s the main way credit card companies make money It is a powerful “force”. This is also how pensions work and why prices seem to rise substantially as we age. Afraid…or at least very wary of compound interest.

Compound Interest Can Really Add Up

Now, let’s look at a more realistic example. Let’s say your credit card has an average outstanding balance of $1,000 and an annual interest rate of 15%.

The interest for the first year is $150. However, this amount is then carried forward and added to the balance, and interest is charged accordingly. Therefore, the interest for the second year will increase by another $172.50, for a total of $1322.50, and continue to increase year after year. Years three, four, and five look like this — $1,520, $1,749, and $2,011.

As you can clearly see, in the 15% case you will owe twice the amount borrowed after only five years, and four times after 10 years. I know it’s hard to believe, but this simple “real world” example once again dramatically demonstrates the power of compound interest.

If you let something like this go on long enough, you end up paying off the same amount of debt year after year, ending up paying back many times the amount you originally borrowed, and in some cases, you may still not fully pay back the initial amount Debt. Unfortunately, most people simply don’t take the time to think about it, thinking that the high and never-ending payments are just their fault for spending too much in the first place.

three percent difference

You might think that there isn’t much difference between a credit card charging 15% APR and one charging 12% APR, but after reading this I’m sure you realize that there is – and that’s exactly what I’m going to show you . Remember the previous example showing you would owe over $2,000 at 15% interest in just five years after borrowing the initial amount of $1,000.

The same example at 12% is shown as follows: first year – $1120, second year – $1254, third to fifth year – $1404, $1573 ​​and $1762 respectively. Over the same five-year period, you could save almost $250, or almost 25% in interest, from a difference of just 3% in APR. Pretty dramatic, hope it helps convince you to make the necessary decision to pay off your credit cards and start saving so you can put “the greatest mathematical discovery ever made” to work for you…while Not against you.

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