How Does Compound Interest Work?
The simple, yet somewhat complicated, definition of compound interest is that it is interest charged on top of interest. Basically, it means that you are paying interest for the total amount of a loan balance, not just the original. Additionally, it can significantly affect how much you owe your lender.
The Principal and Interest
Let’s break down how interest works a little more before we dive into how compound interest works. Say you go out holiday shopping. Using your credit card for purchases, you rack up a $5,000 balance. That balance is what is called the principal – it’s the original amount you borrowed.
Unfortunately, lenders are not in the business of just handing out money; they charge you to borrow from them. That charge shows up in the form of what is called interest. When you open a credit card, your lender will tell you what the annual percentage rate (APR) is for using it for purchases. Although this is referred to as a yearly amount, it’s generally compounded daily.
Calculating Compound Interest
We’ve covered the principal (the amount borrowed) and the interest (what you pay the lender for taking out a loan). Let’s look a little closer at compound interest.
Say when you first opened your credit card, your lender said you had a 15% APR. To understand how much interest you might have to pay after making purchases on the card, it might seem like all you have to do is multiply the balance by the APR, but that’s not generally the case because, as mentioned before, interest is usually compounded daily.
To calculate how much interest you’ll pay on that $5,000, you must first figure out what your daily interest is. Then you must multiply that amount by the loan balance. Then you multiply that product by the number of days in your billing cycle.
Figuring out interest might be hard to see when written out, so we’ll break it down by the numbers:
- Determine your daily interest by dividing your APR by 365: .15/365 = .00041096
- Multiply your daily rate by your loan balance: .00041096 * $5,000 = $2.0548
- Multiply the product by billing cycle days: $2.0548 * 31 = $63.70
The $63.70 is the amount you’ll pay on top of the original $5,000. If you don’t pay the full balance by the due date, you’ll owe $5,063.70.
Now, if you make the minimum payment on your due date, but never actually pay off the card, interest will continue to build up. It doesn’t just accrue on the original loan balance ($5,000); it builds on the entire amount you have on the card. That’s what makes compound interest so powerful (and dangerous). As you might imagine, the higher the balance, the more interest will build.
For Legal Guidance, Contact Albaugh Law Firm
If you’re struggling to make payments on your loans, we can help you understand your debt relief options, such as filing for Chapter 7 or Chapter 13 bankruptcy. We proudly offer skilled legal representation in St. Augustine and the surrounding areas and are ready to provide the counsel you need.