It’s a term you hear about, might know something about, but might not fully understand its implications on your finances. The compound interest I am talking about here is on credit cards, not in your investing portfolio.
I was talking to a good friend recently. She told me that her husband just learned compound interest is and was appalled.
And I totally understand. When you learn that you are paying interest on interest you’ve already racked up, who wouldn’t be appalled?
So let’s look into it and how it’s wrecking your finances.
What is compound interest?
Compound interest is the interest that is accumulating in your account.
Many credit cards have daily compounding interest, which means that the interest that was added to your account is going up daily.
So for every day that you have a balance on your credit card, you are accumulating interest. And it’s not a linear accumulation either; you are paying interest on your principal PLUS the interest that you accumulated yesterday.
That compounded interest is then added up at the end of your billing cycle and added to your overall balance.
Look at the numbers
Say you have a $1,000 balance on your credit card (that’s your principal balance). You have an APR (interest rate) of 20%.
Here’s how it’s calculated by the credit card companies:
- Calculate daily periodic rate (since it compounds daily)
- Calculate average daily balance, using daily periodic rate
- Multiply by days in billing cycle
For our example, we will get:
- 0.2/365 = 0.0005479452 (the rate at which you accumulate interest daily in your billing cycle)
- 0.0005479452 * $1,000 = $0.5479452 (how much interest is accumulated daily in billing cycle)
- $0.5479452 * 31 = $16.9863012 (interest you accumulated that billing cycle)
So, at the end of your billing cycle, you have tacked on another $17 to your bill. Now, when the next billing cycle occurs, you will be paying on a $1,017 principal balance instead of what you actually put on your credit card ($1,000).
Interest will continue to accumulate on your new number.
This also means that, if you make a minimum payment of $17 per billing cycle, you will never even touch your initial principal balance. You will just keep paying on the accumulated interest.
How does this affect you?
The $1,000 example is a very modest amount, based on how much the average American is carrying in debt these days.
If we used the average amount of debt instead, we’re looking at just over $100 of compounded interest at the end of the month! If your minimum payment is at or just under that amount, you’re really only paying interest every month.
You’re not even touching your principal balance.
Since most credit card companies have daily compound interest on accounts, this will likely be how it works for you if you have a credit card.
How do I get out of the compound interest cycle?
We were in that endless cycle too when we were paying off our debt. It was especially discouraging when I saw how much we had already paid in interest alone.
If you want to take the same approach we did to tackle and eliminate your debt, we took advantage of Dave Ramsey’s baby steps. It helped us form our plan to pay off our debt and stop wasting our money on interest payments.
Once we had a budget lined up, we just had to put our noses on the grindstone and pay things off.
It was hard. But now we aren’t wasting our money on interest payments!
That can be your life too.
The first thing you should really focus on is creating a monthly budget. We realized that, when we really looked at our monthly budget, we were out of control. We were spending money right and left, and wondering why we were broke before the next paycheck came.
Once we started with a budget, we allocated our money to categories before we had the chance to spend it. Before we knew it, we actually had money left over before the next paycheck came!
And the best part was, we weren’t depriving ourselves. We were finally just living within our means.
Let’s wrap it up
Compound interest that accumulates on your monthly credit card balance is an unnecessary waste of your hard-earned money.
Getting on a budget, paying off your credit cards, and getting rid of them is the best route to not throwing your money away to big banks.
It is a life change at first, but it can be done! And once you see how much money you can save by just not racking up compound interest, you will wonder why you didn’t start it sooner.