Rates of interest on credit cards

"Compound interest is the greatest mathematical discovery of all time," remarked Einstein. The question you must now ask yourself is, "Do I want this force working for me or against me?" Credit card owners who let amounts roll over from one month to the next face the formidable force of compound interest.

This post is an attempt to shed light on how this "force" manifests itself as interest upon interest and accrues monthly to work against you. And maybe by explaining how this "force" operates and how much even a minor adjustment in the interest rate you're being charged affects your financial future and the future of your family, You may put this "force" to good use by paying off your credit cards and starting a savings plan, which ideally will inspire and push you to do whatever it takes to accomplish these goals.

Compound interest on credit card balances

Credit card interest is compounded monthly, so you'll actually be paying interest on your interest. A simple illustration of this would be the fact that a 2% monthly interest rate does not translate to a 24% annual interest rate. In actuality, your rate would be 26.82 percent. Calculating interest on a monthly basis rather than yearly is a nifty little trick used by credit card firms to snag a few extra percentage points. You end up spending more money without realizing it.

The mental workout of the day

Here's a little puzzle to test your knowledge of what you've already studied. Which would you prefer? $1,000,000 in cold, hard cash or $10,000 in a savings account earning 20% annual compound interest?

Let's examine what would happen to that $10,000 in ten years: $61,917; in twenty years: $383,375; in thirty years: $2,373,763; and in fifty years: $563,475,143.

More than $500,000,000 would be yours after 50 years. Obviously, inflation must be taken into consideration; at a rate of 5% annually, the $500,000,000 would be equivalent to today's $10,732,859. A return of 10% on $10,000 is respectable, but this example also demonstrates yet another lesson about how inflation's compounding rate erodes financial security.

Obviously, that was a difficult question to ask because there are so many factors that could affect your answer, but I think you get the point: compound interest is a potent "force," and it's the primary way credit card companies make money. It's how pensions operate, and it's why the cost of living increases so dramatically as you get older. Take compound interest with a grain of salt, at the very least.

The effect of compound interest can be quite dramatic.

Let's examine a more practical scenario now. Suppose you had a credit card with a 15 percent annual percentage rate and a balance of $1,000.

Interest for the first year would total $150. However, this sum is carried over, added to the existing debt, and subject to interest charges. Interest accrues each year, adding up to a whopping $1322.50 by the end of the second year. For years three through five, we get $1,520, $1,749, and $2,011, respectively.

Five years into paying 15% interest, you'd owe twice as much as you borrowed, and ten years into paying 25% interest, you'd owe four times as much. I know it's hard to believe, but this "real-world" example once again shows how powerful compound interest can be.

If you let it go on for a long enough time, you'll wind up paying back several times as much as you borrowed, and in some cases, you might not even have entirely satisfied the original obligation. Most individuals, sadly, don't stop to consider the full implications of this and instead blame themselves for running up such large and seemingly endless debt loads.

That's a 3% distinction.

Maybe you don't think it makes much of a difference between a credit card with an annual percentage rate of 15% and one with an APR of 12%, but after reading this article, you'll see that there is. Keep in mind that the last example demonstrated that borrowing $1,000 and paying interest at 15% would result in a debt of over $2,000 after only five years.

At a rate of 12%, the identical example demonstrates: In the first year, you'll pay $1120; in the second year, $1254; and in years three through five, you'll pay $1402, $1573, and $1762. Over the same five-year period, a 3% reduction in APR would result in an interest savings of over $250, or nearly 25%. Very dramatic, and maybe it will inspire you to start saving money and paying off your debt so you can use "the greatest mathematical discovery of all time" to work for you instead of against you.

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