Compounding Interest, de-mystified

Compounding interest to many, seems like magic.

You put in $36,000 and by magic you’ve earned $70 at the end of the month for just having your money sit there.

Well, it’s not exactly magic but it is pretty cool when it works in your favour like in the example above.

You get money for having money in the bank, because the bank uses your money temporarily to purchase stocks to make money for themselves, and in return, they pay you for borrowing your cash.

But when compounding interest turns the other way and out of favour, it can be a nasty thing to behold and that’s the angle I’m going to focus on for now:

Let’s assume that on a credit card, you owe $10,000.

If that credit card charges you 19% a year, you’re thinking “Hmm, okay. 19%, that means I pay $1900 in interest a year, or $158.33 a month in interest.”

Well, not so fast!

That’s a SIMPLE way of compounding, because you’re assuming that the credit card calculates that interest that you owe at the end of the year – the $1900 on $10,000 as your outstanding balance, also known as “compounding annually”.

The reality is that credit card companies calculate the interest that you owe at the end of each month, which is what we call “compounding monthly”, and that adds up throughout the year to be more than just a flat 19% in interest.

Compounding = “when the interest gets calculated on the balance”.

The reason why you pay more when a credit card compounds monthly and even sometimes daily, is because they are calculating all those cool little pennies on the balance, and adding to the balance day by day.

And it all adds up in the end.

A penny, here, a penny there, soon you owe an extra money without knowing it because that interest that the bank is saying you owe them at the end of each month gets added to your original $10,000 balance!

Back to my original example:

With a $10,000 balance at 19% a year these are the ACTUAL interest rates you are paying based on when your credit card compounds or calculates the interest.

Daily 20.919%
Weekly 20.883%
Monthly 20.745%
Quarterly (every 3 months) 20.397%
Semi-Annually (every 6 months) 19.903%
Annually 19%

As you can see, the only real 19% is if it’s compounded annually (which it is not), and if it’s compounding monthly you are actually paying 20.754% in compounding interest, or $2075.40 a year.

That works out to be $172.95 a month compared to the original $158.33 you thought you were paying.

That’s a difference of $14.62 a month (not taking into account whether you charge more on the credit card to make the compounding interest worse, or if you pay more on the card than you are asked to each month).

It may seem piddly, but on larger and larger balances, all of those little so-called pennies really add up.

About the Author

Just a girl trying to find a balance between being a Shopaholic and a Saver. I cleared $60,000 in 18 months earning $65,000 gross/year. Now I am self-employed, and you can read more about my story here, or visit my other blog: The Everyday Minimalist.