It's important to understand this key feature of credit cards because it adds to your costs.
Credit cards make it possible to charge purchases and pay for them later. While this may seem attractive, the reality is that cards are a very expensive way to borrow. That's true in part because credit cards charge high interest rates. But there's also another issue that adds costs as well: credit card interest is compounded daily.
Here's what that means for your credit card balance, as well as some details on what you can do about it.
Credit card interest is compounded daily -- and adds to your costs
When you carry a balance on your credit cards, you are charged interest based on how much you owe. For example, if you owe $1,000, then you pay interest equaling a percentage of $1,000, but if you owe $5,000 then you pay interest equaling a percentage of $5,000.
Every time you charge something, it adds to the balance you pay interest on. But it's not just the charges you make that cause this balance to grow. That's because of compound interest.
Most credit cards compound interest daily. This means the interest you owe is added onto your balance.
Here's a simple example of how compounding works. If you owed $5,000 at a 17% interest rate, about $2.32 would accrue on day one. The next day, the interest wouldn't be charged on $5,000. It would be charged on a $5,002.32 balance this time, instead of a $5,000 balance. So you'd accrue about $2.33 in interest on day two, and then the next day you'd owe interest on $5,004.65.
This may not seem like a lot, but all of these interest charges being added onto your card every day will add up quickly. And the higher your interest rate and the higher your balance, the more the costs will pile up over time.
Now, this isn't always the exact way it works in reality because some card issuers charge interest on your average daily balance and compound interest daily, while others will compound interest monthly instead of daily. But this example gives a good indication of what you can expect when interest is compounding over time. Whenever interest compounds, you pay interest on interest and your balance grows.
In most cases, a large portion of your payment will go toward covering this interest cost -- especially if you are paying the minimum amount due -- and your principal balance will decline very slowly, leaving you in debt for years to come.
How to avoid costly credit card bills due to compounding
You do not have to fall victim to this compounding. In fact, it's really easy to avoid owing any interest on your credit cards at all. You just have to pay off your bill in full when your statement comes.
If you pay your bill by the due date, you do not have to worry about any interest being added at any point -- much less the compounding that leaves you paying interest on top of interest charges. You will get the benefits of using a card, including the ability to earn rewards and to help you build credit, but without the big downside of having to pay interest on interest and cover high financing costs.
