Mastering the Art of Credit Card Interest
If we have learned anything from dating apps, ‘interest’ sometimes is the hardest part of all. Fortunately for you, Yofii will always swipe right, so we can make a real connection. Now that we got the creepiness out the way, let’s talk about something that’s even more bewildering, credit card interest.
Credit card interest is usually the part that people understand the least about credit cards. Honestly, unless you’re a math expert, you are like the rest of us, and it hardly makes sense at all. Not understanding credit card interest can be one of the reasons you are here. (HINT: To get out of debt!) Lucky for you, the Yofii team is excited to help you make sense of the ins and outs of interest.
What is credit card interest?
Credit card interest isn’t a one size fits all, so let’s answer the most burning question!
Discover.com defines credit card interest as: the principal way credit card issuers generate revenue. A credit card issuer is a bank or credit union that provides people with credit cards or account numbers that can be used with various payees to make payments and borrow money from the bank.’
To make it simple, credit cards are a business for credit providers and banks, and they make money in a number of ways. The most obvious way credit card companies/banks make money is through the use of interest payments. Another way is APR’s (Check out our last blog post Understanding Your Credit Card APR!) The money you owe (debt) to either credit card companies or banks earns interest over time you owe the credit card company or bank.
If that’s not enough information for you, there’s more! There are two different types of interest banks and credit card companies offer to their customers.
- Simple interest is the less popular cousin of compound interest. This interest is just like its name implies, simple. Simple interest refers to a set percentage that gets added to your balance or principle on a specific timeline. Simple interest is typically added to your balance every year and is rarely used in practice. Many people believe interest rates are calculated as simple interest, but again, isn’t very common in the real world.
- Compound interest is the most popular type of interest. It is loved by banks, investors, credit card companies, and virtually any other type of entity or person who is benefiting from interest. To simplify compound interest, it is interest that gets added onto interest that has been accrued in the past. Compound interest is most likely the type of interest being use on any of the financial products you currently own like: mortgage, savings, credit cards, personal loans, etc.
Albert Einstein is said to have referred to compound interest as “the most powerful force in the universe.” Compound Interest is the reason you need to get out of debt as soon as possible and start saving for your future!
What is the difference between Simple and Compound Interest?
Here are some examples:
- If you have $10,000 in savings with an 8% annual simple interest rate, after your first year of holding the money in your savings account, you will have earned $800 in interest on your account. In the second year, another $800 will be added to your account. This calculation will proceed throughout the life of your account operating under simple interest principles. After your first year, your balance will be $10,800. After your second year, your balance will be $11,600. Since simple interest is so simple let’s calculate your balance after holding your money for 100 years with a simple interest rate. After 100 years, your $10,000 balance will earn $80,000 in interest. Your total account balance will be $90,000.
- If you have the same $10,000 in savings at an 8% annual compound interest rate, you wouldn’t see a difference in the first year. After your first year of holding your money, you will have earned $800 in interest on your account. In the second year, your interest is calculated on your new balance of $10,800, not the original $10,000 like in our simple interest example. In year two, you will receive a new interest payment of $864 for the second year, which gives you a new balance of $11,664. This compound interest will proceed through the life of your account operating under compound interest principles. Since compound interest isn’t simple, let’s calculate your balance after holding your money for 100 years with a compound interest rate. After 100 years, your $10,000 balance will earn $21,987,612.56 in interest. Your total account balance will be worth $21,997,612.56.
If you’d like to calculate your compound interest, check out MoneyChimp’s compound interest calculator!
Sobering Interest Facts:
Interest can be scary, especially when it’s interest on credit cards. Your goal with any balances that accrue interest should always be to pay your balances off as soon as possible. When you make low payments to your balances, it takes you longer to pay it off, which greatly impacts the total amount of interest you have to pay off to get out of debt.
To put things in perspective, MarketWatch.com gives us this scary fact: ’A $2,000 credit balance with an 18% APR (Annual Percentage Rate), with a minimum payment of 2% of the balance, or $10, whichever is greater, would take 370 months or just over 30 years to pay off.’ In this example, if you are making payments of $10 per month to your $2,000 balance, you will pay approximately $3,600 across the 30 years it takes you to pay off your $2,000 of credit card debt. The thought of having the same debt for over 30 years sounds crazy right? The truth is over HALF of all credit card users are making only the minimum payments to their cards every month.
When it comes to credit card debt, people should avoid playing the minimum payment game. If you make minimum payments to your credit cards, a majority of your payment is going to paying the compound interest you’ve accrued, and a small amount of their payment is going towards your actual balance, aka principal. When borrowing from banks or creditors, always check the APR/interest rate and compare them with other offers available in the market place. Low-interest rates benefit users in the long run, and not paying attention to your interest rates can equate to tens of thousands of dollars paid in interest across your financial life.
Sorry if that was scary. Here a cute kitty to help.
We hope this article kept your ‘Interest’ (sorry we had to)
We get it, this is something no one likes to talk about. Unfortunately, the fact that people do not like talking about interest and personal finance is a huge reason why very few people truly understand interest at all. Not understanding interest is one of the top reasons 7 out of 10 people are struggling financially and don’t know how they are going to get out of debt. Yofii’s number one goal is to help you get out of debt! We want to help you understand your finances so you can achieve financial freedom! Want to learn more about interest? Don’t forget to check out our previous blog: Understanding Your Credit Card APR!
Are you ready to take your personal finances into your own hands?