18/05/2023 by Crystal Taylor
How Compound Interest can Work Against You in Debt
Compound interest is, in effect, paying interest on interest. In terms of investments, compound interest is great, but when it comes to debt, compounding interest is a huge set back.
Crowe MacKay & Company's Licensed Insolvency Trustees in Vancouver and Surrey share how compound interest can prolong your debt lifetime and your options to break free from additional compound interest charges. If you require assistance, contact our team in Vancouver and Surrey to start your debt relief journey.
What is Compound Interest?
Compound interest occurs when interest gets added to the principal balance owing and, if not paid in full by the next billing cycle, the interest rate is applied to the current full balance owing, which would include previous interest charges.
Not all lenders charge compounding interest. Certain loans, such as mortgages, student loans, vehicle financing, and personal loans, charge simple interest. Simple interest is calculated using only the principal loan amount and does not include any compounding over time. Most revolving credit, such as credit cards and lines of credit, use the compounding interest method.
How Does Compound Interest Work?
Calculating the interest on your credit card debt can be complicated. If your credit card is not paid in full by the due date, interest is charged using the average daily balance method, which requires dividing your annual interest rate by the number of days in the year to give you the daily interest rate.
Let’s simplify this, imagine you have a credit card debt of $1,000, which has a 19% annual interest rate. If you were making payments of $30 per month, it would take you 4 years to pay off this debt. By the time this is paid off, you would have paid a total of $1,432.90, which means this debt cost you an extra $432.90 in interest.
How Compound Interest Affects Your Debt
Most often, people carry large debt loads for long-time periods. The interest you may be paying each year to maintain your current debt load will add up over time to equal several times more than your principal debt ever was.
The impact of compound interest on your debt repayment has a very real effect. Consider our example above. If there was no interest, at a rate of $30/month, the $1,000 would have been paid in full in 33 months; however, because of the compounding interest, it takes an extra 15 months to repay the full $1,000. This means that the decisions you make now to use credit can affect you for years if you are not making wise decisions.
Credit Card Debt - Making Minimum Debt Payments with Compound Interest
Another danger is falling into the trap of thinking you only need to make the minimum payment required. Minimum payments are designed to keep a debtor in good standing with the credit card company while not paying the card off in full. Doing this means you will be paying off your debt over a longer period of time and will incur a much higher interest charge.
If we once again use our example above but calculate using the minimum monthly payment, it would take a total of 10 years and 5 months to pay off the $1,000 debt and would end up costing $889.40 in interest. This is almost as much as the original debt amount was.
Utilize one of these calculators to analyze your personal situation
How You Can Break Free of the Impact of Compound Interest by Making a Consumer Proposal
It is very important that you weigh the cost of borrowing money over the benefits and time involved before you go into debt. But, what if you are already in debt and feeling trapped? A Consumer Proposal may be an option for you. A huge benefit of a Consumer Proposal is that once an agreement is made with your creditors, there is no interest. The monthly payments you make go 100% to paying off your debt.
If you are struggling with debts, compounding interest is likely costing you more and more each year. At Crowe MacKay & Company, we have over 60 years of experience and offer free initial consultations. If you require support, contact our office today and start your debt relief journey.
This article has been published for general information. You should always contact your trusted advisor for specific guidance pertaining to your individual needs. This publication is not a substitute for obtaining personalized advice.
If you require corporate or personal Insolvency services, Crowe MacKay & Company provides custom solutions for clients, allowing them to live debt-free.