Credit Card Interest Rates - Why It's Important To Understand
How They Work
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. And perhaps, by helping you to 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 families financial future. And 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 based upon what
you've already learned. 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 after 10 years -
$61,917 or 20 years - $383,375 or 30 years - $2,373,763 or 50
years - $563,475,143.
After fifty years, you would have over $500 million. Of course,
you would have to take inflation into account and if we used a
figure of 5% per year, then that $500 million would have the
buying power that $10,732,859 does today. Not a bad return on
your investment of $10,000 but on a side note it also exposes
another lesson in how the compounding rate of inflation destroys
wealth but that's the subject of another article.
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 - but you get my point, the
power of compounding interest and by the way... it's the primary
way credit card companies make their money is a powerful
"force". 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 and 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 out and 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% but then again after
reading this article I'm sure you've realized that there is and
so - that's exactly what I'm going to show you. 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 so that you can put,
"the greatest mathematical discovery of all time" to work for
you... rather than against you.
This article may be reproduced only in its entirety.