Yes, we all know interest rates. We have them on our mortgages, our cars, and our savings. However, how many of us have really considered how much the interest rates really mean? When you stop and calculate the actual differences in rates, these differences can be astounding.
That's why you should always be on the lookout for low interest credit cards; a 0 interest credit card is better. A low rate credit card can help you save hundreds to thousands of dollars. However, there are several things you should know about your credit card rate.
Interest Rates are Compound First, understand that what you owe is compounded. That is, you not only pay interest on a loan, but you also pay interest on past interest which you now owe. This ends up meaning that if you’re paying 2% per month in interest, you’re not paying 24% per year – you’re actually paying 26.82%, a very meaningful difference which can be used to mislead you.
Compound Interest: Exponential Growth
Let’s work through an example using a small amount of money you don’t pay back on a credit card. Arbitrarily put this balance at $1,000, with an APR rate of 15%. After the first year, you will owe $150 of interest, and things only get worse. This amount is then added onto the balance, and interest is charged on that $150 too. The second year, you’d owe another $172.50, for a total of $1322.50. It goes on, with totals of each successive year like this: $1,520.88, $1,749, $2,011.35.
After these five years, you would owe double what you had borrowed. Add five more years, and you owe four times as much! If you let debt like this 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. Since most people ignore the actual amount charged, they assume that they simply spent too much and never see that the interest is the real killer.
A Simple Question
Knowing this, you should be able to easily decipher the following question: would you rather have $1 million, or $10,000 in a savings account earning 20% per year in compound interest?
Let’s calculate the growth of the $10,000. 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 almost 600 million dollars, a simply astonishing number. However, you might have noted that this ignores inflation. If we take a 5% inflation rate into account the amount would still be about 10.7 million dollars, which is still incredible considering we started with ten thousand.
So, now you truly understand 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). Thus, some very sound advice is to be on the saving side of compound interest instead of being a debtor.
Three Percent Difference, a Staggering Amount
Lets consider one other aspect, the difference in results between relatively low changes in interest rates. Returning to the earlier example of the credit card with 15% APR, lets compare this to one with 12% over those same five years. The final result is $1762.34, a difference of $249.01!