The cold hard truth about compound interest
Unless you work for a financial company, and even if you do, it’s probably been a while since you refreshed your knowledge of how compound interest rates – or interest rates overall - work.
First, let’s set the stage.
There are many different types of interest rates, but when we talk about borrowing money we’re most often talking about ether daily simple interest or compound interest. Fairstone loans use daily simple interest, which means, in short, interest is accrued based on the balance of the loan account.
Most credit card companies, on the other hand, use compound interest. With compound interest, interest is accrued based on the balance of the account and existing interest.
Wait … interest on interest?
Exactly. Compound interest means interest is charged on the balance owing of your account, and then the interest is added to the balance owing. Each time interest is charged, it is added to the total debt.
For example, let’s say you have a credit card that charges daily compound interest, and yesterday you carried $100 past its due date.
If you owed $100 yesterday, today you owe that same $100, plus interest. Tomorrow, you’ll owe today’s $100+interest, plus interest. The day after that, you’ll owe the previous day’s $100+interest+interst, plus interest. Every day, interest is calculated based on yesterday’s balance plus interest. That’s why we say the interest is “compounding” on itself.
Credit card companies make exponential profits off unpaid debt."
The good, the bad and the ugly
The good news about compound interest is: if you can nip it in the bud you don’t have anything to worry about. Paying off your credit card every time it’s due means you won’t be charged interest on your purchases.
The cold hard truth about compound interest rates is: by “paying off your credit card”, we mean paying off your credit card in full, 100%, every time it’s due. Not paying the minimum, not paying most of it, but paying all of it. For the 45% of Canadians who carry credit card debt each month,1 paying off their credit card is an unrealistic goal and instead they are left paying interest.
And the ugliest part is that compound interest keeps building into the total debt owed on the credit card, meaning credit card companies make exponential profits off unpaid debt.
Why aren’t more people complaining about this?
Credit card use is a normalized part of life in Canada. Getting your first credit card is a coming-of-age ritual that is required to establish credit and learn how to manage debt. And when used properly, credit cards are an excellent way to make large purchases and earn benefits or points. The issue arises when we are suddenly unable to pay off the debt in full and instead resort to minimum or incomplete payments.
What should I do?
If you’ve gotten caught in a cycle of unpaid credit card debt and compound interest, here are a few steps you can take to stop the spiral and empower yourself as a borrower:
- Familiarize yourself with what type of interest rate your credit provider uses (compound interest, simple interest, or another)
- Find out how often your interest is calculated (daily, monthly, etc.). Knowing how often interest is charged will help you understand how fast your balance could build.
- Pay off your balance in full, or as much as you can, as often as you can
- Add extra payments into your payment schedule so you’re paying more than once a month, reducing overall interest charges on unpaid amounts
- Consolidate your debt when you’re unable to pay it off. A fixed-term, simple-interest consolidation loan can help you pay off your debt faster and reduce overall interest costs over time.
Finally, you can learn about interest rates and how they work by checking out our Interest Rate infographic.
An empowered borrower is a smart borrower, who understands their debts. Familiarize yourself with how a Fairstone loan works by reviewing our loan solutions pages, checking out our payment calculator and finding out “how it works” before you apply. Take control of your finances today.
This article is for informational purposes only. For personalized financial advice, you should contact a qualified financial advisor.
1"General Survey on Consumers' Financial Awareness, Attitudes and Behaviour (Executive Summary)." Financial Consumer Agency of Canada. Government of Canada, 24 Sept. 2013. Web.