Credit Card Interest Rates: Why It’s Important to Understand How They Work
Einstein put it best when he said, “Compound interest is the greatest mathematical discovery of all time.” Now the question to ask yourself is, “Do I want this force to work for me or against me?” If you own a credit card and carry balances from month to month, then you have that incredible force called compound interest working against you.
In this article, I’ll try to explain how this “force” works against you month after month, in the form of interest on interest. And perhaps, by helping you gain a better understanding of how this “force” works and how important even a small change in the interest rate you are charged affects the financial future of you and your family. And hopefully, it will also inspire and motivate you to do whatever it takes to pay off your credit cards and start some kind of savings plan so that you can put this “force” to work for you.
Credit card interest rates are compounded
The interest you pay on your credit card balances is compounded, which means you pay interest on the previous month’s interest. A simple example would be if you were 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 nifty little trick credit card companies use to collect an extra point or two of interest is to calculate the interest monthly instead of annually. You pay more but you don’t know you are paying more.
Here’s a little brain teaser based on what you’ve already learned. Would you rather have $1 million in cash or $10,000 in some type of savings account that earns you an interest rate compounded at 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 more than $500 million. Of course, you would have to take inflation into account and if we were to use a figure of 5% per year, then that $500 million would have the purchasing power that $10,732,859 has today. Not a bad return on your $10,000 investment, but on a side note he also expounds on another lesson about how the compound 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 consider that would influence the decision you would ultimately make, but you get my point, the power of compounding interest and by the way…it’s the number one form of credit . card companies make your money is a powerful “force.” It’s also the way pensions work and the reason the prices of things seem to skyrocket as you get older. Be afraid… or at least be very careful with compound interest.
Compound 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 a 15 percent APR.
The first year’s interest would be $150. However, this amount is then transferred and added to the balance and interest is charged on that. As a result, the second year’s interest would be another $172.50 for a total of $1,322.50 and continues to grow year after year. Years 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 twice 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 compound interest.
If you let something like this go on long enough, you’ll end up paying off the same amount of debt for years and years, and you’ll end up paying many times more than you originally borrowed, and in some cases, you may not have fully paid off the debt yet. original. . Unfortunately, most people just don’t take the time to think about this and feel like the endless high payments are simply their fault for spending too much money to get started.
The three percent difference
You may feel like there isn’t much of a difference between a credit card that charges 15% APR and one that charges 12% APR, but after reading this article I’m sure you’ve realized that there is and so on. : that’s exactly what I’m going to show you. Remember the example above that showed you owe more than $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 – $1,120, year two – $1,254, and years three through five – $1,404, $1,573, and $1,762 respectively. After the same five-year period, you would have saved almost $250 or almost 25% in interest with a 3% difference in APR. Pretty dramatic and hopefully it will help convince you to make the necessary decisions to pay off your credit cards and start saving so you can put “the greatest mathematical discovery of all time” to work for you… instead of on your against. You
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