As people begin worrying about a coming U.S. recession, some have expressed a concern with getting out of credit card debt. This is a smart personal finance move in any situation, but it is especially timely now, as economic uncertainty looms. Here is a question I received about getting out of credit card debt:
I keep trying to pay off my credit cards, but even paying more than the minimum doesn’t seem to make much of a dent. Why is it so hard to pay off my credit card debt?
This is an excellent question, and when I first started trying to tackle my own credit card debt halfway through college, I was similarly befuddled. But the answer is simple. And rather distressing: Most credit card companies charge compound interest.
What is compound interest? And why is it so terrible?
Compound interest is the practice of taking an interest charge and adding it to the balance of your loan. This means that you pay interest on your interest charges, as well on the principal of your loan.
Like most things to do with money, compound interest itself is neither good nor bad. It’s your individual situation that makes it so. If you are saving money in an account, compound interest works in your favor. You increase your earnings. Unfortunately, most of us are on the other side of compound interest. This means that you increase the amount of money you pay in interest charges. In other words, you pay even more for the privilege of borrowing money.
Credit card companies charge interest on your interest. And, to make the arrangement even more profitable for them, they use a daily accrual system. This means that credit card companies take your annual rate and divide it by 365. Then, at the end of the day, that number is multiplied by your loan balance to get your interest charge. The result is added to your daily credit card balance. A simple illustration:
You have $4,500 on your credit card and an annual interest rate of 15.99%. Your daily rate is 15.99/365 = 0.0438082, or (0.000438%). Multiply that by $4,500, and you have a $1.97 interest charge. The next day, your balance is $4,501.97. Multiply that by your daily interest rate, and you end up with an interest charge of $1.98, which is added to the balance for a total of $4,503.95.
While it may not seem like a lot at first, you can see how if it happened every day, by the end of 30 days you would have accrued somewhere between $60 and $75 (or more) in interest charges.
And if you have more than one credit card, or more money in credit card debt, you can see how it becomes difficult to pay down all that debt. After all, before any money is applied to the principal, it is first applied to the interest. So, even though you may be paying a great deal each month, it is not all going to reduce your debt as fast as you would like.