How does compound interest compound your financial situation?

2020-08-09   minute read

John Haralovich

Debt Solutions

Lifestyle Debt

Many people ask me why their debts keep increasing, even though they’ve stopped using credit and are making all their payments on time and in full every month. Often, this is due to a widely held belief that the minimum payment is always equal to the monthly interest charges ­— which isn’t always the case.

It’s important to understand the role of compound interest in inflating the value of high interest debts and how it can make them even more difficult to repay. Also, how you can avoid falling prey to compound interest in the future. 

Two people looking at a laptop with paper spreadsheets and charts on the table

What is compound interest?

Compound interest is the process of charging (or earning) interest on interest.

This can be highly beneficial when you’re investing because every month you can earn additional interest on the interest you earned over the previous months. But it can be debilitating when applied to debts because your lender will charge interest on any interest you haven’t paid over the previous months.

How does compound interest work?

On certain high interest debts, usually credit cards, the minimum monthly payment will not cover all the interest charged over the previous month. The credit provider will charge interest on any outstanding interest on your next month’s statement.

For example, imagine you have a credit card with a 20 percent interest rate. Your balance is $10,000 and your monthly interest charge $167. However, your minimum monthly payment is only $100.

If you only make the minimum payment, you will carry $67 in interest over to the following month — which your credit card provider will charge interest on as well. Even if you do not make any additional purchases on your credit card, making only the minimum payment over the next year would increase your outstanding debt from $10,000 to $10,800.

How to avoid paying compound interest on your debts

The easiest way to avoid paying compound interest is to avoid interest charges in the first place. If you have a credit card or a line of credit, aim to pay the balance off in full before your monthly statement arrives in the mail.

If you currently have a balance that you’re trying to pay off, make sure any payments you make are high enough to repay any interest your lender has charged over the previous month. The following three tips can help you better understand the impacts of compound interest on your debts and help you overcome them.

Know your interest rate — Read your credit agreement carefully and pay attention to the annual percentage rate (APR). Be extremely cautious of any interest rate higher than 10 percent. Note that most credit cards charge around 20 percent on average.

Know how to read your statement There are three pieces of information you always need to know: (1) your total balance, (2) your interest charges, and (3) your minimum payment. The only way to reduce your debt is to pay more than your monthly interest charges. If you cannot pay the interest charges at the very least, it may be worth considering whether credit is right for you right now.

Know when to ask for help — If you can only afford the minimum payments and your debts keep increasing, contact a licensed professional for help crafting a plan to reduce your debt. This could include assistance creating a budget that allows for larger monthly debt payments or evaluating a formal debt solution such as Bankruptcy or a Consumer Proposal.  

Life-Changing Debt Solutions

If you find your monthly cash flow is not sufficient to service your financial commitments, MNP may be able to help you get the financial fresh start you need. Contact us for a Free Confidential Consultation to find out your options today.  

During this no-obligation initial meeting a Licensed Insolvency Trustee will review your entire financial situation and identify solutions to address your debt. These may include Bankruptcy or a Consumer Proposal — which provides your creditors with a negotiated set repayment and avoids further interest. 

No matter the options available to you, a Licensed Insolvency Trustee will provide an unbiased opinion about your best path forward, and help you make the best decision for your unique situation.

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