What is compound interest?

For years, you’ve heard about how compound interest is your friend, when it comes to savings or investments. But if you’re in the market for a loan, compound interest is something you should approach with extreme care. A compound interest loan is a frenemy at best.

Compound or compounded interest is basically interest on interest. It’s a method of calculating interest on loans or revolving credit that charges the interest rate (say 20%) on the principal balance as well as the accumulated interest amounts from prior periods.

It’s a bit complex, so let’s break it down:

If I borrow $1000 for three years at a 20% simple annual interest rate with monthly payments, my loan payments look like this:

A lot of numbers, I know. But you can see clearly that each monthly payment is $37.16, and that each month more of the payment is devoted to paying down principal. This is because you are only paying interest on outstanding principal – not on the interest amount. So while most of the early payments go to interest, by the time you get to month 36, only 61 cents is going to interest and $36.55 goes to principal. This is the same way most mortgages work.

Now let’s look at compounding interest.

Compounding interest is basically “paying interest on interest.” It works by effectively increasing your principal by the amount of interest calculated on a monthly, or daily basis. It’s the way almost all credit cards work. There is a really cool tool on bankrate.com that helps make sense of compounding interest. In the example below, we have $1,000 of credit card debt. If we make only the minimum payments (here we set the minimum at 2% per month), you can see it takes 9 years and 9 months to pay it off, and the total payments will be $1,851.03.

There are a few things to keep in mind here. First, the example assumes you don’t charge any more money to the card during the almost 10 year pay down period. Second, it assumes you continue to make minimum payments. As a result, your payments get smaller during the pay down period. Third, your monthly payments are less than the $37.66 in our simple interest example. In this example, your payment starts at $20.00 per month, and drops for the first 40 months until it gets to $15.00. Then you’ll pay $15.00 for 68 months.

If you start making $35.00 monthly payments on a 15% credit card with a $1,000 balance (and don’t charge any more on the card and make 3.5% minimum payments), you’ll pay $1,422.40 over 72 months to pay the card off.  (Keep in mind your payments drop over time.)  Here’s a screen shot of the bankrate.com calculator using this example:

We used these examples (20%, 3-year, simple interest vs. 15% compounding at 2% and 4% minimums) to show how compounding works – even when the quoted interest rate is lower for the credit card.  The interest payable and time frames get much higher and longer in compounding scenarios as the interest rate climbs.  If we take the credit card rate up to 20%, and keep the 2% minimum, the total due will be $3,126.33 over 16 years and two months.

Suggestion:  go to the bankrate.com calculator http://www.bankrate.com/calculators/credit-cards/credit-card-minimum-payment.aspxand put in your credit cards and minimums (if you pay the minimum each month, and outstanding balances and see what it says your total payments and time frame will be.  You may be surprised.