Einstein put it best when he said, "Compounding
interest is the greatest mathematical discovery of all time". Now the
question you need to ask is, "Do I want this force working for me or
against me?" If you own a credit card and you carry-over balances from
month to month then you've got that amazing force called compounding interest
working against you.
In this article, I'll attempt to explain how this
"force" works against you month after month after month, in the form
of interest upon interest. And perhaps, by helping you to gain a better
understanding of how this "force" works and how important even a
small change in the interest rate you are being charged affects you and your family’s
financial future. And hopefully, it will also inspire and motivate you to do
whatever it takes to pay off your credit cards and initiate some type of
savings plan so you can put this "force" to work for you.
Credit Card Interest Rates are Compounded
The interest you pay on your credit card balances are
compounded, which means that you pay interest on the 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.
A Brain Teaser
Here's a little brain teaser based upon what you've already
learned. Would you rather have $1 million in cash or $10,000 in some form of
savings account earning 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, you would have over $500 million. Of
course, you would have to take inflation into account and if we used a figure
of 5% per year, then that $500 million would have the buying power that
$10,732,859 does today. Not a bad return on your investment of $10,000 but on a
side note it also exposes another lesson in how the compounding 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 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.
Compounding 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.
First-year 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 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.
If you let something like that carry on long enough, you end
up paying on that same amount of debt for years and years and end up paying
back many times what you originally borrowed and, in some instances, you still
may not have completely satisfied the original debt. Unfortunately, most people
simply don't take the time to think through this out and they feel that the
high and never-ending payments are simply their fault for spending too much money
to begin with.
The Three Percent Difference
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.
That same example at 12% reveals the following: Year one -
$1120, year two - $1254 and years three through five - $1404, $1573 and $1762
respectively. After the same five year period, you would have saved nearly $250
or almost 25% in interest from a mere 3% difference in APR. 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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