Compound interest can be good or bad. In a savings or investment account, compound interest can help your money grow over time. But if you have a loan or an unpaid balance on your credit card, compound interest can make it harder to pay off your debt because the interest you owe keeps growing. That’s why it’s important to understand how compound interest works and to use it to your advantage.
Let’s take a look at what compound interest is, how it can work for you and what you should avoid.
What is compound interest and how can I use it to earn money?
In a savings or investment account, compound interest is the interest you earn on money that has already earned interest.
Here’s an example of how to figure compound interest if you were to invest $5,000 in a savings account that earns 5% interest per year.
- In the first year, you will earn $250 in interest.
- In the second year, you will earn $262.50 in interest, because you will have earned interest on your original $5,000 investment, plus the $250 in interest you earned the first year.
- In the third year, you will earn $275.62 in interest on your original $5,000 investment, plus the $250 in interest you earned the first year, plus the $262.50 in interest you earned the second year.
And it keeps going from there! Remember, interest rates change over time, so the amount of interest you earn may go up or down each year—but the longer you keep your money invested in an account that earns interest, the more interest you will earn.
How does compound interest work with credit cards?
Credit card companies don’t wait until the end of the year to tack on interest charges. Instead, they calculate compound interest loan charges daily. So, for example, if you have a $1,000 unpaid balance and your credit card has an Annual Percentage Rate (APR) of 20%, your balance will increase by .055% each day:
- Day 1 Balance: $1,000.55
- Day 2 Balance: $1,001.10
- Day 3 Balance: $1,001.65
- Day 4 Balance: $1,002.20
And it keeps increasing from there.
Plus, if you don’t pay your credit card bill monthly, the credit card company will charge you late fees. This means you’re paying interest on:
- The money you owe your credit card company.
- Interest on additional money (interest) the credit card company has added to your balance.
- Late fees.
This is how credit card debt can quickly get out of control—even a small credit card balance can turn into a big problem if you don’t pay it off completely and on time.
How to Avoid Interest Payments on Credit Cards
Credit card companies give you a grace period, which is a period of time—typically a month—after you make a purchase before they start charging interest. If you pay your balance in full before the grace period ends, you won’t owe any interest. However, if you don’t pay your balance in full, the credit card company will start charging you interest on the remaining balance. The longer you take to pay off your balance, the more interest you will owe.
It’s always best to pay your credit card balance in full each month— and if you can’t afford to pay it all off at once, try to pay as much as you can afford. This will help you minimize the amount of interest you owe.
Struggling to pay off your credit card balance? Think about setting up a budget for yourself. It’s a simple way to help you keep an eye on your spending and on track to meet your financial goals.
If you need help, we can create an affordable plan that works for you. Visit nationaldebtrelief.com or call 888-353-0207 today to get started.