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What You Need to Know About Interest Rates
For all people shop around for the best rate, there are few
who have taken the time to sit down and add it all up. After all,
why would you bother? The answer is that understanding just how
interest rates work can help you see how important small
differences in rates and payment amounts can be.
Interest Rates are Compound.
It is important to remember that what you owe is compounded -
that means you pay interest on the interest you owe from the
month before. That means that if you're paying 2% per month in
interest, you're not paying 24% per year - you're actually paying
26.82%. Charging interest monthly instead of yearly is a trick to
make it feel like you are paying a very low price for your
borrowing.
A Thought Experiment.
Here's a question: would you rather have $1 million, or
$10,000 in a savings account earning 20% per year in compound
interest?
Well, let's see how that $10,000 would grow. After 10 years:
$61,917. 20 years: $383,375. 30 years: $2,373,763. 40 years:
$91,004,381. 50 years: $563,475,143.
So after fifty years, you'd have over $500 million?! Well, not
so fast. Of course, you have to take inflation into account - if
we say inflation is 5%, then that money would have the buying
power that $10,732,859 does today. Still, that's not a bad return
on your investment of $10,000, is it?
That's the power of compound interest, and the way the credit
card companies make their money (it's also the way pensions work,
and the reason the prices of things seem to rise massively as you
get older). Be very, very afraid of compound interest. Or, of
course, you could start saving, and be very glad of it?
Compound Interest Adds Up.
Let's work through an example on a more real kind of scale.
Let's say you have an average unpaid balance of $1,000 on a card
at 15% APR.
You will owe $150 in interest for the first year you borrow.
However, this amount is then added onto the balance, and interest
is charged on that. The second year, you'd owe another $172.50,
for a total of $1,322.50. It goes on, with totals like this:
$1,520.88, $1,749.00, $2,011.35.
After just five years at 15%, you'd owe double what you
borrowed. And after 10 years, you'd owe four times what you
borrowed! Bet you weren't expecting that. If you let something
like that carry on for long enough, you'll end up paying back
that credit card for years afterwards, paying back what you
borrowed many times over and still not clearing the debt. Most
people don't work this out, and feel that the payments must
simply be their fault for spending too much money to begin
with.
One Percent of Difference.
One more thing. You might think there's not that much
difference between a card that charges 15% APR and one that
charges 12% APR. Let's see the difference the lower rate would
make to that $1,000 borrowed for five years. Remember, after five
years at 15%, you owed $2,011.35.
At 12%: $1,120, $1,254.40, $1,404.93, $1,573.52? $1,762.34
after five years. So you've saved $249.01 from that 3% difference
in APR - in other words, you've paid almost 25% less
interest.
Ken Austin is the webmaster at Debt Consolidation
Solutions and Credit Relief
Solutions
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