Compound interest and why low interest rates are important

Getting a lower interest rate on a card may seem like a sensible thing to do, but something that can be put off.  After all it’s only a couple of per cent on a card balance.  But this couple of per cent can mount up over the years.

The reason why it is important to pay attention to even small differences in interest rates is that the amount of money that builds up via interest increases very fast.  This is known as compound interest.

Many people think of interest in the terms of what is known as simple interest, where interest is only charged on the original balance.  So if a credit card balance in $1,000 and the interest rate is 10% then the charge on the balance will be $100 in the first year, $100 in the second year, $100 in the third year and so on.

However most credit cards operate a system of compound interest, where interest is charged on both the original balance and any interest that is on top of that.  So with the $1,000 credit card balance there will still be $100 charged in the first year, but there will be $110 charged in the second year.  This will be the $100 charged on the $1,000 balance and the $10 that is charged on the interest that was added to the balance.  In the third year the interest will be $121 and will keep on growing.

This means that apparently small differences in interest rates can have a big difference over a number of years.  So the difference between 18% and 20% interest over a ten year period is a 23% difference in the amount of interest that is charged, and the difference would account for 95% of the original balance.  With both these interest charges the debt has multiplied by around six times the original amount.

Another lesson from compound interest is that as well as getting the lowest interest credit cards over the long term, that when making repayments it is better to make repayments on cards that have the highest interest rate rather than those with lower interest rates.  Through compound interest the careful aiming of repayments to the highest interest credit cards will mean that the principle balance can be paid off in the fastest way, and this minimises the interest that is paid and so the time that the debt is paid off in.