The simple, yet somewhat complicated, definition of compound interest is
that it is interest charged on top of interest. Basically, it means that
you are paying interest for the
total amount of a loan balance, not just the original. Additionally, it can
significantly affect how much you owe your lender.
The Principal and Interest
Let’s break down how interest works a little more before we dive
into how compound interest works. Say you go out holiday shopping. Using
your credit card for purchases, you rack up a $5,000 balance. That balance
is what is called the principal – it’s the original amount
Unfortunately, lenders are not in the business of just handing out money;
they charge you to borrow from them. That charge shows up in the form
of what is called interest. When you open a credit card, your lender will
tell you what the annual percentage rate (APR) is for using it for purchases.
Although this is referred to as a yearly amount, it’s generally
Calculating Compound Interest
We’ve covered the principal (the amount borrowed) and the interest
(what you pay the lender for taking out a loan). Let’s look a little
closer at compound interest.
Say when you first opened your credit card, your lender said you had a
15% APR. To understand how much interest you might have to pay after making
purchases on the card, it might seem like all you have to do is multiply
the balance by the APR, but that’s not generally the case because,
as mentioned before, interest is usually compounded daily.
To calculate how much interest you’ll pay on that $5,000, you must
first figure out what your daily interest is. Then you must multiply that
amount by the loan balance. Then you multiply that product by the number
of days in your billing cycle.
Figuring out interest might be hard to see when written out, so we’ll
break it down by the numbers:
Determine your daily interest by dividing your APR by 365: .15/365 = .00041096
Multiply your daily rate by your loan balance: .00041096 * $5,000 = $2.0548
Multiply the product by billing cycle days: $2.0548 * 31 = $63.70
The $63.70 is the amount you’ll pay on top of the original $5,000.
If you don’t pay the full balance by the due date, you’ll
Now, if you make the minimum payment on your due date, but never actually
pay off the card, interest will continue to build up. It doesn’t
just accrue on the original loan balance ($5,000); it builds on the entire
amount you have on the card. That’s what makes compound interest
so powerful (and dangerous). As you might imagine, the higher the balance,
the more interest will build.
For Legal Guidance, Contact Albaugh Law Firm
If you’re struggling to make payments on your loans, we can help
you understand your debt relief options, such as filing for
Chapter 7 or
Chapter 13 bankruptcy. We proudly offer skilled legal representation in St. Augustine
and the surrounding areas and are ready to provide the counsel you need.
Schedule a free initial case evaluation by calling us at (904)637-1839 or
contacting us online.