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Credit
Card Interest Rates:
What You Need To Know
Everyone shops around for the best rates, but there are few
who have actually 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 Compounded.
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 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 dollars
now 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 $1322.50. It goes on, with totals like this:
$1,520.88, $1,749, $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%: $1120, $1254.40, $1404.93, $1573.52… $1762.34 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.
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by SolveYourProblem.com
: 2006
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