Understanding Debt - Compound Interest on Credit Cards
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“ Einstein was once asked what was the most powerful force in the Universe?” He replied: “Compound Interest!”
For peace of mind and financial independence you want life as free of stress as possible. You do not want creditors chasing you and making life uncomfortable. Credit Card Chaos begins something like this: You receive an offer in the mail, telling you a “such and such” credit card is waiting with your name on it.! It will allow you to borrow up to $1000 and you need not pay back more than $20.00 per month. The interest rate is 18%, but it could be a lot higher. It sounds like an unmissable deal, especially as you have been wanting to upgrade your computer for some while.
Before buying the computer do the math:
Stop! Don’t rush out the door with this newly acquired piece of plastic, but instead take a calculator and do the sums. How long is it going to take to pay off this new $1000 super computer at a mere $20.00 per month? Read the small print and you will see that the usual minimum repayment is 2% of the total debt. In this case 25 of 100 is $20.00. This payment includes compound interest charges and is not simply restricted to the capital cost of the computer!
How to calculate compound interest:
How much interest are you paying each month on your new computer? Divide the interest rate, in this case 18% by the number of days in the year (360) 18 360 = 0.05. Next you multiply this by the number of days in the month (30) 0.05 X 30 =1.5. Then you multiply the 1.5 by 1000. The answer is 15. You pay $15 per month in interest charges and only $5.00 towards discharging the capital sum. What’s more astounding is that if you continue paying off the debt in this way it is going to take you almost 30 years to pay for the computer. What’s more you will have paid almost $2500 in interest. The super computer has ended up costing you $3500. I can guarantee one thing; it will not be around when you have finished paying off your debt.
Calculating compound interest is a long and complex set of calculations if you intend to do it manually. There is a formula and you will find it easily enough on line. The reason it is so complicated is that the numbers change each time and it becomes difficult to keep track of them.
You will find compound interest calculators on line, too. Use them to do the sums and mark my words you will be in for a good number of shocks! You will find a link to an online compound interest calculator here. You can play with this example and see how it works. I notice the interest figure is slightly different from my manual calculation but the result is the same. You are paying the bank a lot of money to borrow money to buy your new computer.
Some Suggestions:
Start a savings plan. Put $20.00 into it each month. You will have $240.00 in the account at the end of the year. You will also earn a small sum in interest. Let’s say $10, but this rate will depend. At end of year 1 you will have $250.00 in the bank. At the end of year 2 you will be in the region of $520.00 and at the end of year 3 it will have grown to almost $800.00. You could probably buy an adequate computer at that price. It is a cash payment and you will have no monthly payments. It just takes a little longer, that’s all! A little time gives you the opportunity to explore the market and find out what bargains lie out there and how to get them. Impulse purchases have to be satisfied now, and seldom get you great deals!
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