For all people shop around for the best rate, there are few who have taken the time to sit down and add it all up. After all, why would you bother? The answer is that understanding just how interest rates work can help you see how important small differences in rates and payment amounts can be.

Interest Rates are Compound.

It is important to remember that what you owe is compounded that means you pay interest on the interest you owe from the month before. That means that if youre paying 2% per month in interest, youre not paying 24% per year youre actually paying 26.82%. Charging interest monthly instead of yearly is a trick to make it feel like you are paying a very low price for your borrowing.

A Thought Experiment.

Heres a question: would you rather have $1 million, or $10,000 in a savings account earning 20% per year in compound interest?

Well, lets see how that $10,000 would grow. After 10 years: $61,917. 20 years: $383,375. 30 years: $2,373,763. 40 years: $91,004,381. 50 years: $563,475,143.

So after fifty years, youd have over $500 million?! Well, not so fast. Of course, you have to take inflation into account if we say inflation is 5%, then that money would have the buying power that $10,732,859 does today. Still, thats not a bad return on your investment of $10,000, is it?

Thats the power of compound interest, and the way the credit card companies make their money (its also the way pensions work, and the reason the prices of things seem to rise massively as you get older). Be very, very afraid of compound interest. Or, of course, you could start saving, and be very glad of it

Compound Interest Adds Up.

Lets work through an example on a more real kind of scale. Lets say you have an average unpaid balance of $1,000 on a card at 15% APR.

You will owe $150 in interest for the first year you borrow. However, this amount is then added onto the balance, and interest is charged on that. The second year, youd owe another $172.50, for a total of $1,322.50. It goes on, with totals like this: $1,520.88, $1,749.00, $2,011.35.

After just five years at 15%, youd owe double what you borrowed. And after 10 years, youd owe four times what you borrowed! Bet you werent expecting that. If you let something like that carry on for long enough, youll end up paying back that credit card for years afterwards, paying back what you borrowed many times over and still not clearing the debt. Most people dont work this out, and feel that the payments must simply be their fault for spending too much money to begin with.

One Percent of Difference.

One more thing. You might think theres not that much difference between a card that charges 15% APR and one that charges 12% APR. Lets see the difference the lower rate would make to that $1,000 borrowed for five years. Remember, after five years at 15%, you owed $2,011.35.

At 12%: $1,120, $1,254.40, $1,404.93, $1,573.52 $1,762.34 after five years. So youve saved $249.01 from that 3% difference in APR in other words, youve paid almost 25% less interest.