Compound interest can work for you or against you. When it works for you, it helps your money grow faster in savings or investment accounts. But when it works against you, it makes loans and credit card debt much harder to pay off since the amount of interest you owe keeps growing larger over time.
To make the most of your money, understanding credit card compound interest is very important. Let’s take a look at what compound interest is, how it can work for you, and what you should avoid.
When Compound Interest Is a Good Thing
In a savings account or investment account, compound interest means you earn interest not just on your original money, but also on the interest you have already earned. Here is an example of how it works if you put $5,000 in a savings account that pays 5% interest each 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. This is interest earned 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! Now you’re earning interest on $5,512.50. This process continues over time, with your interest earnings getting a little bigger each year.
Keep in mind that interest rates can change from year to year based on economic conditions. But in general, the longer you are able to keep your money in an account that earns compound interest, the more your money will grow.
Credit Card Compound Interest in Action
So how does compound interest work when it comes to things like credit card debt? With credit cards, interest charges are usually calculated on a daily basis, not just once per year.
Let’s say you have a credit card with a balance of $1,000 and an annual interest rate (APR) of 20%. On this card, your daily interest rate would be about 0.055% (20% divided by 365 days). So here’s how your debt would grow each day:
After 1 day: $1,000.55
After 2 days: $1,001.10
After 3 days: $1,001.65
After 4 days: $1,002.20
As you can see, the debt keeps getting a little bigger each day. In addition, if you miss a monthly payment, you will likely owe late fees on top of the interest charges. So in the end, you are paying interest on three things:
- The original amount of money you borrowed
- The additional interest charges that get added to your debt each day
- Any late fees you are charged for missing payments
It’s easy to see how this can cause credit card debt to spin out of control very quickly. Even a relatively small amount of debt can grow to a very large amount over time if you are not able to make your payments on time and in full each month.
If you’re curious about how much compound interest you might earn or owe, the U.S. Securities and Exchange Commission has a free compound interest calculator on their website.
How to Pay Less Interest
Credit card companies typically give you a “grace period” of around 25-30 days to pay for your purchases before they start charging you interest. If you pay off your entire balance within this grace period, you will not owe any interest at all.
But if you carry a balance past the grace period, the credit card company will begin to charge interest on the remaining amount. The more time it takes you to pay off your balance, the more interest you will rack up.
The lesson here is that the best way to avoid paying credit card compound interest is to pay your balance in full each and every month. If you’re not able to pay the full amount, pay as much as you possibly can.
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