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What Is Compound Interest?

4-Minute Read

Almost every day, our mailboxes get flooded with credit card offers. They are so tempting, even though we know credit card debt is a major problem for many American families. The question remains, though: Why do we indulge?

It’s because we see the credit available to us, but often miss the interest calculation and the trap it creates: compound interest.

What Is Compound Interest?

Compound interest is, literally, interest on TOP of interest. Interest is calculated at a designated interval, and then added to the principal, so that the next time interest is calculated, it is calculated against the sum of the principal plus any previously earned interest.

How Does Compound Interest Work?

Say you put $100.00 in a savings account that earns 1% interest, compounded daily. On the first day, you’ll earn interest of $0.01. On the second day, you’ll earn another 1% interest, only this time it will be 1% of $100.01. At the end of the first year, your account will contain $101.01. After Year 2, your account will contain $102.02. In Year 10, it will contain $110.52.

Compound Interest Vs. Simple Interest

By contrast, without compounding, after the first year, your account would contain $100.01 ($100 x 1% = $0.01). After Year 2, you would only earn another $0.01, bringing you to $100.02, because the interest is only calculated against the principal. This is called simple interest. After Year 10, the account would contain $100.10.

Compound Interest: The Saver’s Friend, The Debtor’s Enemy

Compound interest is a double-edged sword. It makes building real wealth much easier, but it can drag you into financial ruin on the flip side.

Savings Vs. Debt

In the above example, we looked at a savings account from the saver’s perspective. Now let’s consider it from the debtor’s point of view.

If you’re a person with excellent credit, you’re probably charged an average credit card interest rate of about 16%. If your credit is average, it’s probably around 20%, and around 23% if your credit is shaky. It’s a whopping average of around 26% if you take a cash advance, regardless of your credit. And those enormous interest rates are compounded daily.

Revolving Credit

In our above example of your savings account, we loved compounding!

But as debtors, we might feel a bit differently:

Let’s imagine you had an average American credit card balance of $7,000, per household, and your credit is average. Let’s also assume you transfer that balance to a credit card that didn’t require any payments for the first year, and you neither make payments nor charges to the account (highly unrealistic, by the way – but it makes the math much easier).

At the end of that year, you would owe $8,549.35.

The Compound Interest Formula

The compound interest formula is A = P (1 + r/n)^(nt).

  • A — final amount
  • P — Initial principal balance
  • r — Interest rate
  • n — Number of times interest is compounded per time period
  • t — Number of time periods

Here’s the math:

Image of compound interest formula A= P(1+r/n)^nt

So that means:

Balance After Year 1   = $7,000 (1 + .20/365)365x1

And applying our old friend PEMDAS (order of operations):

                                    = $7,000 (1.0005479452)365x1

                                    = $7,000 (1.0005479452) ^ 365

                                    = $7,000 (1.2213358558)

                                    = $8,549.35 (after rounding off)

This Is How Credit Cards Get You

So after Year 1, you’d owe $1,549.35 ($8,549.35) just for carrying that debt.

In addition to being expensive, when credit cards bill you, the minimum amount due represents the interest charges for that month only. So, if you pay only the minimum amount due, your principal balance does not go down at all.

You’ll have to pay the same amount next month, and the month after, and so on, without ever touching your overall debt – yet you can keep charging, all the way up to your credit limit.

A Better Way To Owe: Installment Loans

Fortunately, there is a way to get off the inclining, credit card debt treadmill.

What Is An Installment Loan?

An installment loan is a loan that charges simple interest on the debt you owe. It is paid off monthly, like a mortgage payment or an auto loan, both of which are examples of installment loans. A debt consolidation loan like those offered at Rocket Loans is also a type of an installment loan, designed for making debt manageable.

Revolving Credit Vs Installment Loan

With revolving credit, your debt can keep climbing, and your bill can vary widely from month to month. With an installment loan, you borrow what you need, and also get a reasonable timeframe to repay it. You pay interest and pay down your principal with every month’s payment, and your monthly bill doesn’t change.

Unlike credit card debt, you’ll know exactly when you will have repaid your debt – and with every payment, the light at the end of the tunnel burns brighter.

Final Thoughts

It’s easy to get in over your head with credit card debt, and once submerged, it’s hard to see a way out. But there is an exit in sight. Apply for one of our personal loans today and we’ll help you put your debt behind you.

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