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

Einstein said it well when he said, “Compound interest is the greatest mathematical discovery of all time.” Now the question you need to ask yourself is, “Do I want this force to work for me or against me?” If you have a credit card and carry over balances from month to month, you have this incredible force called compound interest working against you.

In this article, I will attempt to explain how this “force” is working against you month after month after month, in the form of interest on interest. And perhaps, helping you better understand how this “force” works and how even a small change in the interest rate you’re charged affects you and your family’s financial future. And I hope it also inspires and motivates you to do whatever it takes to pay off your credit cards and start some type of savings plan so you can put that “strength” to work for you.

Credit card interest rates are compounded

The interest you pay on your credit card balances is compounded, which means you pay interest on the previous month’s interest. A simple example would be that if you had to pay an interest rate of 2% per month, you would not pay 24% per year. In reality, you would pay 26.82%. A little trick that credit card companies use to get an extra point or two of interest is to calculate interest on a monthly rather than annual basis. You pay more but you don’t know you are paying more.

A puzzle

Here’s a little puzzle based on what you’ve already learned. Would you rather have $1 million in cash or $10,000 in a savings account that earns you 20% compound interest per year?

Hmm, let’s see how that $10,000 would increase 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 dollars. Of course, inflation would have to be taken into account and if we used a figure of 5% per year, then that $500 million would have the purchasing power of $10,732,859 today. That’s not a bad return on your $10,000 investment, but by the way, it also exposes another lesson in how the compound inflation rate destroys wealth, but that’s for another article.

Obviously this question was a little tricky as there are so many variables to consider that would influence the decision you would ultimately make – but you get what I mean, the power of compound interest and by the way… it’s the primary way credit card companies make their money is a powerful “force.” It’s also how pensions work and why the prices of things seem to rise massively as you get older. Be afraid…or at least be very wary of compound interest.

Compound Interest Can Really Add Up

Now let’s look at a more real example. Let’s say you have an average outstanding balance of $1,000 on a credit card with an APR of 15%.

The first year’s interest would be $150. However, this amount is then carried forward and added to the balance and interest is charged on this amount. As a result, the second year’s interest would be an additional $172.50 for a total of $1,322.50 and it continues to accumulate 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 owed double what you borrowed and after 10 years you owed four times. I know it’s hard to believe, but 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 end up paying back many times over what you originally borrowed and in some cases you don’t you may still not have fully satisfied the original debt. . Unfortunately, most people just don’t take the time to think about it and they feel that the endlessly high payouts are simply their fault for spending too much money in the first place.

The three percent difference

You may think there isn’t much difference between a credit card that charges a 15% APR and one that charges a 12% APR, but again after reading this article, I’m sure that you realized there is and so – that’s exactly what I’m going to show you. Recall the previous example that showed you owed over $2,000 after only 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 would have saved almost $250 or nearly 25% in interest from a mere 3% difference in APR. Pretty dramatic and I hope this helps convince you to make the decisions necessary to pay off your credit cards and start saving so you can put “the greatest mathematical discovery of all time” to work for you… rather than against you.

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