The Compound Effect

Compounding interest could easily be referred to as the “eighth wonder of the world,” and for good reason. Thanks to compound interest, a relatively small amount of money can grow into a large amount of money relatively quickly. The concept of compound interest is pretty straightforward. Simply stated, compound interest is when existing interest earns interest. For example, a $1,000 balance that earns 5% interest each day. Day one you earn $50 interest on that $1,000. Day two you earn $52.50 interest on the new balance of $1,050. Day three you earn $55.125 on the new balance of $1,102.50, and so on. The amount of earned interest will continue to increase daily as the previously earned interest is added to the balance. 

Credit card companies often rely on the fact that you may not completely understand how your interest is accrued. Therefore, you need to protect yourself by understanding how your interest is compounding. The term “compound interest” means that any interest is added to the principal or the amount you started with so that your original amount grows exponentially.

For a moment, let’s compare basic interest, which is a fee that you pay to a lender to borrow money. Basic interest is attached to the original amount at an agreed upon rate. Compound interest is calculated on the balance owed plus any previous interest charges. Ultimately, you end up paying interest on the interest. This compounding continues until it practically takes on a life of its own. Credit card lenders make considerable profits putting this principle to work for them.

Based on this model, the concept of compound interest could be considered a great asset or a detriment. Naturally, when the interest is being earned the compounding effect is beneficial. When the interest is owed, however, the compounding effect can be equally costly and financially harmful. In any event, the impact to your credit can be drastic. Compound interest is neither inherently good nor bad and how it affects you depends on the situation. When you have money invested in an interest bearing account compound interest works to your benefit by allowing you to grow your balance more quickly. When you have credit card debt, however, compound interest work against you by making it more difficult to pay down your debt.

If you pay off the balance of your credit card quickly, compounding interest will not cost you as much. Where compound interest can really be problematic is if you carry a balance on your credit card and only pay the minimum payment. The minimum payment is typically calculated as a percentage of the outstanding balance, usually 2%. When you pay the minimum payment your money goes towards paying off your interest charges first. Whatever is left over is then put towards paying off the principal. Consequently, you are paying down your balance much slower. 

It’s quite clear which end of the compound interest principle spectrum you should be working to be on. The first step toward the winning side is to pay off your existing debts. Even if you may already be having trouble making ends meet, a mere $1 addition to a minimum payment can significantly shorten the life of the loan. Yes, you read correctly, just a single dollar. You will not miss a single dollar and it would be a dollar well spent. Remember the compounding effect. Once you are out of debt, there is no minimum for earning compound interest. Any money that you do not absolutely need to live on could potentially be put aside. You don’t need to be Donald Trump or Bill Gates in order to benefit from compound interest. It can work wonders people like you and I.

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