If you’re a saver, compound interest is your friend, steadily boosting your savings over time. However, if you’re in debt, it is a formidable foe that can have a significant negative impact on your financial well-being. We take a look at how compound interest escalates debt.
Compound interest: savings booster or debt escalator
We’ve already covered the benefits of compound interest as a savings booster in this series of articles. The snowball effect of compound interest makes it a powerful tool for building wealth and one that savers can use to their benefit.
Unfortunately, it is also the reason that debts grow and spiral out of control, making billions in profit for credit card companies every year and causing financial distress to many people.
If you are in the habit of making unnecessary purchases on credit, understanding how compound interest escalates debt may just make you change your ways. Even if you feel that you are in control of your debt, you’re still spending unnecessary money on interest payments. It’s simply not a smart way to manage your finances.
Compound interest and debt: how it works
You decide you deserve a luxury breakaway. You can’t really afford it, but that’s what credit cards are for, right? You book the flights and a swanky hotel in a tropical idyll and stick $5,000 on your credit card. No worries, it’s only $5,000.
Compound interest can easily turn a debt of ‘Only $5,000’ into thousands more, particularly if only the minimum payment is made each month. Here’s how:
Let’s say your credit card charges interest of 20% APR and the minimum monthly payment is calculated at 4% of the outstanding balance.
After the first month, interest of $83.33 is added to the debt, bringing your balance to $5,083.33.
You make the minimum payment of 4%, which is $203.33, leaving you with a balance of $4,880. Your debt has only reduced by $120 despite you paying $203.33.
If you carry on this way indefinitely, making only the minimum payment each month, it will take you approximately 11 years and 6 months to pay off the debt.
During this time, you’ll end up repaying a total of $11,300 on a $5,000 debt. That’s $6,300 in interest alone.
Compound interest as a foe
It’s clear that, when applied to debt, compound interest is your foe. If you don’t pay the entire balance on your account each month, it can significantly extend the time it takes to repay debt and substantially increase the total amount you repay compared to the original borrowed sum.
It is also important to note that loans don’t compound annually. They may compound monthly, weekly, or daily. The shorter the interval, the more quickly loan interest will accrue. Credit card interest is typically compounded daily.
The upshot is that however manageable you think your credit card debt is, compound interest is working against you.
Prioritise getting unsecured debts paid off, start saving and you’ll be on the flipside, making compound interest your friend, rather than your foe.
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