Compound versus Non-Compound Interest
Interest charged on your credit card balance is compounded. This means you are charged interest on the interest charged!
Compound interest does not work in the same way as regular interest. Regular, non-compound interest merely charges you interest on your outstanding balance. It works in the following way:
After three months you have been charged interest on your outstanding balance three times.
When interest is compounded however, the debt grows much more rapidly. Essentially, the longer you take to repay the debt, the quicker it grows, because interest accumulates on previous interest charges: this is what is known as compounding. If you pay off the total outstanding balance each month, you do not need to worry about interest nor compounding interest: you will never need to pay these charges. However, if you are unable to pay off your balance in full you should be aware that your debt will quickly accumulate; you will be charged interest on any outstanding balance, and if you do not clear this debt the following month you will be charged interest again plus interest on the previous month's interest. Compound interest works in the following way:
After three months: you have been charged interest three times on your outstanding balance; have been charged interest twice on interest charged in previous months; and have been charged interest on interest earned on interest in a previous month. Your debt is increasing at a much faster rate. To take the additional cost of compounding into account the APR (Annual Percentage Rate), which indicates the interest rate charged on your card, is not simply twelve times the monthly interest rate. It is higher than a basic percentage multiplied by twelve, to account for the interest charged on the interest charged.
Since credit card interest rates are high, the effect of compounding is great: the interest charged each month is a large percentage of the outstanding amount. The cost of compounding can be very large. If you were to borrow five thousand pounds at a rate of ten percent interest over ten years and did not make repayments, it will cost you just over £12,960. If you borrowed the same amount at a regular, non-compounded interest rate of ten percent, it would cost you £10,000: a saving of nearly three thousand pounds.
It is important to repay as much of the outstanding balance as you can afford: the lower your repayments, the longer it will take you to repay your debt, and the more it will cost you. For more information see Minimum Repayment.
