Compound interest is the process of earning interest not only on the amount of money you deposit but also on the accumulated interest. In other words, you earn interest on both the original amount deposited and the interest generated on that deposit. But compound interest can also be applied to debt.
When it comes to savings or investments, compound interest works in our favor, allowing our money to grow faster over time. But with debt, compound interest works against us, making our debt grow over time. Credit cards and loans typically charge compound interest. Let’s consider an example of credit card debt:
Suppose you have a credit card balance of $1,000 with an annual interest rate of 20% compounded monthly. At the end of the first month, the interest on your debt would be $16.67 (20% divided by 12), making the total balance $1,016.67. In the second month, you would be charged interest not only on the original $1,000 but also on the additional $16.67. This process continues, and if you only make minimum payments, compound interest can cause your debt to grow significantly over time. This is why making just the minimum payment required by the credit card companies (many borrowers think of this as “staying current”) really doesn’t do anything to reduce the amount of debt owed. An important law adopted several years ago requires credit card statements to show the number of years it will take to pay off debt if only minimum payments are made.
During consultations I often ask potential clients how they want to live their lives. Do they want to spend decades repaying credit card debt or do they want to be out of debt and live a different type of life? Each of us has to make that choice. Personally, I believe life is too short for anyone to spend more than a few years paying off unsecured debt. Almost every one of us has too few dollars saved for retirement. Some of us have college accounts that need to be created for our children. Each one of us knows of charities that deserve our money.
Understanding compound interest is crucial when we’re trying to save money. But the practice of compounding interest on debt owed can often lead to people needing to look at bankruptcy as the way to break the burden of too much debt that might take decades to repay otherwise. Contact Nancy Thompson Law Office to talk about how bankruptcy can work to put you on a different path.