How Compound Interest Works With Credit Cards (Everything You Should Know)

By Minh Tong Reviewed by Nima Vahdat Updated May 29, 2024
How Compound Interest Works With Credit Cards (Everything You Should Know)

Credit cards offer the convenience of making purchases now and paying for them later, but this convenience comes at a considerable cost. 

Not only do credit cards typically have high-interest rates, but they also have compound interest, further increasing the overall expense of borrowing.

Below, we’ll explore how compound interest works with credit cards and provide tips on how to manage it effectively.

KEY TAKEAWAYS:

  • Compound interest can work in your favor when saving or investing, but it can also lead to significant debt accumulation when applied to credit card balances.
  • Credit card interest is compounded daily, which means that your debt can grow rapidly if not paid off in full each month.
  • To avoid falling victim to the pitfalls of compound interest on credit cards, it’s important to pay off your balances in full and on time whenever possible.

What Is Compound Interest And How Can I Use It To Earn Money?

Compound interest is the interest calculated on the initial principal and also on the accumulated interest of previous periods. In simple terms, it means earning interest on interest. 

This concept can work in your favor when saving or investing money over time. By reinvesting the interest earned, your savings can grow exponentially over time, thanks to the power of compounding. 

Imagine you deposit $1,000 into a savings account with a 1% annual interest rate, compounding annually. After the first year, you’d earn $10 in interest, bringing your balance to $1,010. 

If you don’t add any more money, the next year you’d earn 1% interest on the new $1,010 balance, totaling $10.10 in interest and increasing your balance to $1,020.10. 

This cycle continues, with each year’s interest calculated on the higher balance. While the impact may seem minor on a $1,000 balance, it becomes more significant with higher interest rates and balances.

How Does Compound Interest Work With Credit Cards?

Compound interest on credit cards refers to the process where interest is calculated not only on the initial principal amount owed but also on any accumulated interest that has been added to the balance. 

This means that as interest accrues, it is added to the outstanding balance, and future interest charges are calculated based on the new, higher balance. 

For example, let’s say you have a credit card balance of $1,000 today with an annual interest rate of 22%. 

If you make no payments for the entire year, at the end of the year, you would owe $1,220 ($1,000+22% interest). 

However, if the interest is compounded daily, the calculation would be more complex.

Each day, the interest is added to the balance. 

So, after the first day, you would owe $1,000.06 (($1,000 + (22%/365)) = $1,000.06). 

Then, for the second day, interest would be calculated on this new balance of $1,000.06, resulting in a slightly higher interest charge. 

This process continues each day, with interest being added to the balance and recalculated based on the new total.

To calculate the balance on a $1,000 credit card with a 22% APR considering daily compounding after one year, we’ll use the compound interest formula:

A=P×(1+r​/n)nt

Where:

P = $1,000 (principal amount),

r=0.22 (22% expressed as a decimal),

n=365 (compounded daily), and

t=1 year.

Plugging in these values:

A=1000×(1+3650.22​)365×1

Calculating:

A≈1224.94

So, the balance on the $1,000 credit card with a 22% APR, considering daily compounding, would be approximately $1,224.94 after one year. And that’s assuming you made no other purchases on that card!

Over time, compound interest can significantly increase the amount you owe, especially if you only make minimum payments or carry a balance for an extended period. 

This is why it’s crucial to understand how compound interest works and to pay off credit card balances as quickly as possible to avoid accumulating excessive debt.

How To Beat Daily Compounding Credit Card Interest

You don’t have to fall victim to this compounding.

Beating daily compounding credit card interest involves strategies to minimize the impact of compounded interest charges on your credit card balances. 

Here are some simple tips…

Pay your balance in full each month: By paying off your entire credit card balance before the end of the billing cycle, you can avoid accruing any interest charges altogether.

Make more frequent payments: Instead of waiting until the end of the billing cycle to make a single payment, consider making smaller payments throughout the month. This can help reduce the average daily balance on your credit card account, thereby lowering the amount of interest that accumulates.

Pay more than the minimum: If you’re unable to pay off your balance in full, aim to pay more than the minimum payment required each month. By paying more, you can reduce the principal balance faster and minimize the amount of interest that accrues.

Use a balance transfer: Consider transferring your high-interest credit card balances to a card with a lower promotional interest rate or a 0% introductory APR offer. This can help you save money on interest charges while you work to pay down your debt.

Negotiate a lower interest rate: Reach out to your credit card issuer and ask if they’re willing to lower your interest rate. If you have a good payment history and credit score, they may be willing to negotiate a lower rate, which can help reduce the impact of compounding interest.

Avoid cash advances: Cash advances often come with higher interest rates and fees compared to regular credit card purchases. Avoid taking cash advances whenever possible to minimize the amount of interest you’ll owe.

Some Final Thoughts On How Compound Interest Works With Credit Cards

Compound interest can be a powerful tool for growing your savings or investments over time, but it can also work against you when applied to credit card debt. 

Understanding how compound interest works with credit cards is essential for avoiding debt accumulation and maintaining financial stability. 

If you’re struggling with credit card debt and compound interest, we can help.

At Americor, we understand the importance of managing your finances wisely. 

As America’s trusted source for debt relief solutions, we aim to empower you with financial knowledge that can lead to informed decisions, whether it’s about savings, investments, or managing debt.

If your debt has become unmanageable and you have difficulty making your debt payments each month, then you should consider a free consultation call with one of our certified Debt Consultants, who can provide personalized advice tailored to your specific needs.

By taking proactive steps today, you can put an end to your financial stress and work towards a brighter financial future. 

Remember, there is always hope for debt relief, and our team of experienced professionals are ready to guide you on your journey to regaining control of your finances.

For more information on Americor’s debt relief services, contact us today to see how we can help you eliminate your debts, and get on the fast-track to becoming completely debt-free!


minhtong

Minh Tong

Minh leverages decades of experience in marketing, sales management and technology to provide high-level advice and lead new initiatives. Minh has a Bachelor of Science in Business/Managerial Economics from University of California at Irvine. He brings over 20 years of sales and executive management experience to the company and his responsibilities include customer service improvement, professional development, and carrying out communications and marketing. Originally from the east coast, Minh resides in southern California and enjoys spending time with his family, going to the beach, and playing a variety of sports.