Don’t Let Compound Interest on Credit Cards Take You to the Cleaners
By Eva Norlyk Smith, Ph.D.
May 22, 2009
Take a guess: How long will it take to turn a penny into $10.7 million if you double it every day? 30 years? 10 years?
How about 30 days? Due to the power of compounding interest, if you double a penny every day, it will actually turn into $10.7 million in only 30 days. Compound interest is such a powerful force that Albert Einstein referred to it as the eighth wonder of the world.
The concept of compound interest is great when you put money in the bank because it can turn a small investment into a fortune over 30-40 years. Unfortunately, when it comes to credit card debt, the power of compound interest works against you. Unless you know how to take the bite out of compound interest, it will keep you in the stranglehold of credit card debt for a long, long time.
So what exactly is compound interest? Each month, the interest your credit card company charges on credit card debt becomes part of the debt principal for the next month. So next month, you also pay interest on the interest. This repeats itself the following month, but now you also pay interest on the interest of the interest from the previous month, and so on. This is compounding interest. In this example, the interest compounds once a month. Some credit cards, however, compound the interest daily, making it an even more powerful force to surmount.
Compound interest grows exponentially. It starts out slowly, and then speeds up and grows faster and faster. In the example of the penny that doubles each day, after 15 days, it has still only turned into $327—a long way from $10.7 million. But that $327 keeps doubling, and at 20 days it’s $10,485. Double that for another 10 days, and you’ve got your $10.7 million.
When it comes to credit card debt, it fortunately doesn’t double each day, or we’d all be bankrupt. However, as this example shows, the longer one holds on to debt, the more the power of compound interest works against you.
There are three factors that increase the power of compounding: high interest, high levels of debt, and holding the debt for a long time. This deadly combo will speed the accumulation of compounding interest and will deny the ability to paying off debt for a very long time. Unfortunately, for many people, this is exactly what happens when they pay only the minimum due on their credit cards each month.
For example, let’s say you have $10,000 in credit card debt at a 19.99% APR. If you pay only a minimum payment of, say, 2% of the balance owed each month, due to the power of compound interest, it will take you 84 years to pay off your credit card debt. During that time, you’ll pay around $48,000 in interest, almost five times the original amount charged. Such is the power of compounding interest.
Want to know how to neutralize the force of compounding and save BIG money on your credit card payments? See our article on How to More than Double Your Money with Your Credit Cards.