Einstein put it best when he said, “Compound interest is the greatest mathematical discovery of all time.” Now, the question to ask yourself is: “Do I want this force to work for me or against me?” If you own a credit card and carry balances from month to month, then you have that amazing force called compound interest against you.
In this article, I’ll try to explain how this “force” works against you month after month after month, in the form of interest upon interest. And perhaps helping you better understand how this “force” works and how important, even a small change in the interest rate you are being 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 that you can put this “force” 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 they were charging you an interest rate of 2% per month, you would not be paying 24% per year. In reality, you would be paying 26.82%. A little trick credit card companies use to collect an additional point or two of interest is to calculate interest monthly rather than annually. You pay more but don’t know you are paying more.
A puzzle
Here is a little puzzle based on what you have already learned. Would you rather have $ 1 million in cash or $ 10,000 in some form of savings account that earns 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, it would have more than $ 500 million. Of course, you’d have to factor in inflation and if we were to use a 5% per year figure, then that $ 500 million would have the purchasing power that $ 10,732,859 has today. It’s not a bad return on your $ 10,000 investment, but on a side note, it also lays out another lesson on how the compound rate of inflation destroys wealth, but that’s the subject of another article.
Clearly, that question was a bit tricky because there are so many variables to consider that would influence the decision I would ultimately make, but you get my point, the power of compound interest, and by the way … it’s the primary way to get credit. Card companies make your money a powerful “force.” It’s also the way pensions work and the reason the prices of things seem to go up massively as you get older. Be scared … or at least be very careful with compound interest.
Compound 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.
The first year interest would be $ 150. However, this amount is rolled over and added to the balance and interest is charged on that. As a result, the second year interest would be another $ 172.50 for a total of $ 1,322.50 and it continues to accrue 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 twice as much as 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 over years and years and end up paying off what you originally borrowed many times over, and in some cases, you may not have fully satisfied the original debt yet. . Unfortunately, most people just don’t take the time to think about this and feel that the high and endless payments are simply their fault for spending too much money to get started.
The three percent difference
You may feel like there isn’t 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. and so … that’s exactly what I’m going to show you. Remember the previous example that showed you owe more than $ 2,000 after just five years at 15% after borrowing a starting amount of $ 1,000.
That same 12% example reveals the following: Year One – $ 1,120, Year Two – $ 1,254, and Years Three through Five – $ 1404, $ 1573, and $ 1762 respectively. After the same five-year period, you would have saved nearly $ 250 or nearly 25% in interest from a mere 3% difference in APR. It’s pretty dramatic and hopefully will help 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” in your favor … instead of against. you.
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