Credit card interest rates – why it’s important to understand how they work
Einstein put it best when he said, “Compound interest is the greatest mathematical discovery of all time.” Now the question you need to ask is, “Do I want this power to work for me or against me?” If you own a credit card and carry balances from month to month, then you have this incredible power called compound interest working against you .
In this article I will try to explain how this “force” works against you month after month after month, in the form of interest after interest. And perhaps by helping you better understand how this “force” works and how important even a small change in the interest rate you are charged affects the financial future of you and your families. And hopefully it will also inspire and motivate you to do whatever it takes to pay off your credit cards and start some kind of savings plan so you can put this “power” to work for you.
Credit card interest rates are complicated
The interest you pay on your credit card balance is compounded, meaning you’re paying interest on top of the previous month’s interest. A simple example would be if you were charged 2% interest per month, you would not be paying 24% per year. In reality, you’ll be paying 26.82%. A neat little trick that credit card companies use to get an extra point or two in interest is to calculate the interest on a monthly rather than annual basis. You’re paying more, but you don’t know you’re paying more.
Here’s a little puzzle 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 you 20 percent compound interest per year?
Hmm, let’s see how that $10,000 will grow in 10 years – $61,917 or 20 years – $383,375 or 30 years – $2,373,763 or 50 years – $563,475,143.
In fifty years you will have over $500 million. Of course, you’ll need to factor in inflation, and if we use a figure of 5% per year, then that $500 million would have the purchasing power of $10,732,859 today. Not a bad return on your $10,000 investment, but on a side note it also reveals another lesson about how rising inflation destroys wealth, but that’s a topic for another article.
Clearly, this question was a little tricky because there are so many variables to consider that would affect what decision you end up making – but you get my point, the power of interest compounding and all. .. this is the main way credit card companies make their money is a powerful “force”. This is both how pensions work and why the prices of things go up significantly as you get older. Beware…or at the very least, be very wary of accruing interest.
Compound interest can really add up
Now let’s look at a more real-world example. Let’s say you have an average outstanding balance of $1,000 on a credit card with an APR of 15 percent.
The interest for the first year will be $150. However, this amount is then carried forward and added to the balance and accrued interest. As a result, the interest for the second year will be another $172.50 for a total of $1,322.50 and continues to increase year after year. Years 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 will owe double what you borrowed, and after 10 years you will owe four times. I know it’s hard to believe, but once again this simple “real world” example dramatically demonstrates the power of compound interest.
If you let something like this go on long enough, you end up paying the same amount of debt for years and years and paying back multiple times what you originally borrowed, and in some cases, you may still not have fully paid off the original debt. Unfortunately, most people just don’t take the time to think this through and think that the high and never-ending payments are simply their fault for spending too much money to begin with.
The three percent difference
You might feel like there isn’t that much of a difference between a credit card that charges a 15% APR and one that charges a 12% APR, but after reading this article, I’m sure you’ve realized that there is – just that I will show you. Remember the previous example that showed you’d owe over $2,000 in just five years at 15% after borrowing an initial $1,000.
This same example at 12% reveals the following: Year One – $1,120, Year Two – $1,254, and Years Three through Five – $1,404, $1,573, and $1,762, respectively. After the same five-year period, you’d save nearly $250, or nearly 25% in interest, from just a 3% difference in APR. Pretty dramatic and hopefully helps convince you to make the decisions you need to pay off your credit cards and start saving so you can put the “greatest mathematical discovery of all time” to work for you … instead of against you.
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