Understand the Compounding Effect of Interest on Credit Cards

The majority of people understand that they are charged an interest rate on their credit cards. This means that you ultimately pay back more than you borrow, a condition that borrowers are willing to accept because it means that they can purchase the items that they want immediately rather than having to save up money to pay the full amount up front. However, many consumers don’t really understand the way that interest compounds over time which can be a problem for people who are carrying large balances. This is something that you should learn about if you really want to be a savvy credit card consumer who understands where all of your money is going.

Basically, what you need to understand is that the credit card interest rate that you are charged is based on the outstanding balance that you have on the credit card. People who are paying off only the minimum payment on their credit cards sometimes aren’t even covering the entire interest rate charge for the month. This means that the balance in the second month is higher than the balance in the first month and therefore the interest charged is greater in the second month. As times goes on, this interest can keep compounding to the point where it gets out of control.

This is confusing so consider an example. You have a balance of $5000 on your credit card. The interest rate is 10%. Your minimum payment is only $25 so you don’t actually pay the entire interest rate on the card. You reduce your bill by $25 but increase it by significantly more than that because of the interest rate on the card. This means that the following month, your balance will actually be higher than $5000 even though you paid $25 towards the card. On top of the fact that you aren’t paying down the debt, your next round of interest is going to be calculated on the new amount which is greater than $5000.

This becomes a particular problem for people who are running a debt that is very close to their credit line maximum. Those people may find that the compounding interest rate ultimately leads them to exceed their credit limit which results in an additional fines and fees for most borrowers. These additional fees are added to the debt and then the interest is applied to the new higher amount. You can see how people’s debt starts to get really out of control. This can be managed to some degree by understanding the impact of compounding interest. Regardless of what the minimum payment is on your credit cards, you want to make sure that you are paying off more than the interest accumulated that month to keep from suffering from this type of compounding interest debt problem.

This entry was posted on Thursday, September 11th, 2008 at 12:23 pm and is filed under Debt & Consolidation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.