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Escape The Compound: How To Leave Compound Interest Behind
Sure you're being charged interest. But are you being charged interest on your interest? Here's a quick guide to understanding compound interest and how to avoid it.
There are two components to your credit card bill that you always need to keep in mind: the principal and the interest. The principal is the amount of money that you actually spent; the interest is a fee that you've been charged based on a percentage of the principal.
For example, if you spend $100 on a credit card with 5% monthly interest, you would owe a total of $105 the following month. In this scenario, even though you owe $105 total, the $100 principal remains the same and the 5% interest is counted separately. So if another month goes by and you are charged that interest again, you would still be charged 5% based on the $100 principal. The interest would be an additional $5 and you would owe a total of $110.
This is where compound interest enters into the equation. With compound interest, any interest charged is added to the principal. Instead of owing a $100 principal and a $5 interest, you would now owe a $105 principal. So far, so good. Right? You still owe the same amount of money as you did before.
Not so fast. The following month, instead of being charged 5% of the $100 principal, you would now be charged 5% of the $105 principal. Instead of owing $5.00 more, for a total of $110.00, you would owe $5.25 more, for a total of $110.25.
"Wow. A whole extra quarter. That's really going to bust my budget," you say, sarcastically. Well, if you only ever owe $100 on your card then, yes, the compound interest probably won't hurt too bad. Even so, the thing about compound interest is that it adds up over time. And it adds up to quite a lot.
Using the same metrics — 5% interest charged and compounded monthly — you would owe $171.03 after one year on that original $100 principal. So while you only spent $100, you would now owe an additional $71.03 in interest. That's an extra $.71 for every $1.00 spent. And if you had a $1,000 balance, you would owe $710.34 in interest. If you had a $10,000 balance? A whopping $7,103.39 in interest would be due. The more you spend, the more the interest adds up (learn more in What You Should Know About Interest Rates).
Now, the credit card in that previous example would have an APR of 60% (5% interest x 12 months). Most credit cards do not have an APR that high. However, while most cards have a lower APR, they also do not compound monthly; they compound daily. So a $10,000 balance on a credit card with a 20% APR and interest compounded daily would become a $12,206.91 balance after one year. That's an extra $2,206.91 in interest.
It's things like compounding interest that make credit card debt especially difficult to pay off. Accumulate a large enough balance at a high enough interest rate and, pretty soon, the interest owed each month alone becomes more than you can afford to pay.
One possible way to pay down your credit card debt and escape from compound interest is to take out a personal installment loan. The major reason is that the interest on these products does not compound. Your principal never gets larger. It only ever gets smaller as you pay it off. Even if the APR on your loan is slightly higher than the APR on that credit card, the absence of compounding interest makes it easier to manage and still possibly cheaper. You simply use the loan to pay off that credit card and then you pay off the loan in easy monthly installments. Doing this for multiple credit cards and/or other debts is called 'debt consolidation.'
When you take out an installment loan, you will know up-front how much you are going to pay each month. This might make it easier to budget appropriately. Additionally, most of these loans have repayment periods of 36 months or longer — depending on the size of the loan and other factors — so you don't have to spread yourself so thin to pay it back on time. Getting rid of your credit card debt and paying your installment loan on time every month could also increase your credit score.