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

Executive Summary about Credit Card Interest by Kevin Erickson

Credit Card Interest Rates are Compounded

The credit card interest you pay on your credit card balances are compounded, which means that you pay interest on the credit card 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.

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.

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 credit card 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 credit card 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.

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.

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.

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This blog post was posted on Thursday, February 26th, 2009 at 3:21 pm and is filed under Credit Card Interest. You are able to see any type of responses to this blog post via the RSS 2.0 feed. You can give your responses, or trackback directly from your own blog.