Compound Interest: Friend or Foe?
Have you ever looked at your credit card bill and thought, ‘How could it possibly be this high? I hardly used my credit card this month’? This is likely due to one of two things. Either your credit card has been stolen (in which case, you should call your credit card company, but then come back and finish reading this article, you might learn something), or you are on the back end of the compound interest animal.
Compound interest occurs when interest is charged or earned on the prior month’s interest. When you owe money on a loan, this can get expensive quickly, as in the case of the credit card bill. When you have a savings that you are earning interest on, compound interest helps you grow your money more quickly.
The good kind of compound interest
You may have seen bank advertisements showing 2% interest, 2.018% APY. (Bonus points if you know what APY stands for). If you didn’t earn the bonus points, APY stands for Annual Percentage Yield and basically means, after keeping your money in that account for a year, your money will be larger by 2.018% over your original deposit. The bank does this by giving 2% interest each month, so month 1 earns 2% on the original deposit, (usually called the principal), month 2 earns 2% interest on the principal AND the interest from month 1, and so on.
Here is an example to show how it works:
Earning Compound Interest (Friendly Compound Interest)
Annual Interest Rate: 2%, Compounded Monthly, 2.018% APY
Compounding monthly at 2% interest as above, is the same as if the bank just paid interest once a year at a rate of 2.018% as below.
2.018% Interest, Not Compounded
$1000.00 x 2.018% = $1020.18
It’s rare to see banks that don’t compound their interest, so it’s not so much something to look for, as much as it’s just a good concept to understand. And now you can feel like a brain when your friends ask what APY means.
It’s probably even more important to understand compound interest on the other end, when a lender is charging you compound interest on a loan. This is when things get expensive for you. One more thing to notice is that interest earnings tend to be low, maybe 2% or 3% in recent history is considered a really good interest rate, while interest rates on loans tend to be much higher, creating a much larger impact when it comes to compound interest.
Loan Interest (Foe Compound Interest)
Credit Card Balance: $1000
Minimum Monthly Payment: $50
Annual Interest Rate: 14.24%, Compounded Monthly
In the example above, after a year of paying the minimum balance, you have spent $600.00 and only paid off $488.68 of the original $1000 bill. You have paid $111.32 in interest and it will be almost another year before the bill is paid off completely. This is, of course, assuming no additional purchases are put on the credit card. I don’t know know about you, but I can think of a lot of things I would prefer to spend $111 on than interest.
Every month your credit card isn’t paid back in full, you pay interest on that balance. The next month, you pay interest on the balance AND the interest from the month before, if it hasn’t been paid. Credit Cards have notoriously high interest rates, which is how the interest piles up so quickly and people get into trouble trying to pay them off. Check out our article on Credit Cards to learn about what to look for and if it makes sense for you to have one.