Compound interest

How does compound interest make credit card payments more expensive?

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It’s important to understand this key feature of credit cards because it increases your costs.

Key points

  • Credit cards are a common form of borrowing.
  • It is expensive to maintain a balance on credit cards due to high interest rates.
  • Compound interest can worsen a credit card balance because it accumulates over time and adds to your existing debt.

Credit cards allow purchases to be billed and paid for later. While that may sound appealing, the reality is that cards are a very expensive way to borrow. This is partly true because credit cards charge high interest rates. But there is also another problem that also adds costs: interest on credit cards is compounded daily.

Here’s what that means for your credit card balance, plus some details on what you can do about it.

Interest on credit cards is compounded daily and increases your costs

When you carry a balance on your credit cards, you are charged interest based on the amount you owe. For example, if you owe $1,000, you pay interest equal to a percentage of $1,000, but if you owe $5,000, you pay interest equal to a percentage of $5,000.

Every time you charge something, it adds to the balance you pay interest on. But it’s not just the fees you incur that increase this balance. It’s because of compound interest.

Most credit cards charge daily interest. This means that the interest you owe is added to your balance.

Here is a simple example of how composition works. If you owed $5,000 at 17% interest, about $2.32 would accrue on the first day. The next day, interest would not be charged on $5,000. It would be charged on a balance of $5,002.32 this time, instead of a balance of $5,000. So you’ll accrue about $2.33 in interest on the second day, then the next day you’ll owe interest on $5,004.65.

It might not seem like a lot, but all those interest charges added to your card every day will quickly add up. And the higher your interest rate and balance, the more the costs will add up over time.

Now, that’s not always exactly how it works in real life, as some card issuers charge interest on your average daily balance and compound interest daily, while others will charge interest compounded monthly instead of daily. But this example gives a good indication of what you can expect as interest accrues over time. Each time the interest is compounded, you pay interest on the interest and your balance increases.

In most cases, a large portion of your payment will be used to cover these interest charges – especially if you pay the minimum amount due – and your principal balance will very slowly decrease, leaving you in debt for years to come.

How to avoid expensive credit card bills due to compounding

You don’t have to fall victim to this composition. In fact, it’s very easy to avoid paying interest on your credit cards. Just pay your bill in full when your account statement arrives.

If you pay your bill when it’s due, you don’t have to worry about interest being added at some point, let alone capitalization that requires you to pay interest on top of the billing fee. ‘interest. You’ll get the benefits of using a card, including the ability to earn rewards and help you build credit, but without the big inconvenience of having to pay interest on interest and cover costs high funding.

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