Compound Interest - Debt

How Compound Interest is Calculated on Debt

Credit card and loan interest is typically accrued daily and compounded monthly. This means that interest builds up every day and is added to the total balance at the end of the month. To calculate how much interest accrues each day, we can use this formula:

How to Minimize the Cost of Compound Interest on Debt

There are two main methods lenders use to calculate the minimum monthly payment. 

• For installment loans, such as personal and auto loans, the minimum monthly payment is calculated to repay the debt within a specified repayment period, such as five or seven years. 

• Credit cards are handled differently. The minimum monthly payment on a credit card is calculated as a small percentage of the total balance. These percentages typically fall between 1-3 percent of the total balance. Some companies will set minimum dollar amounts such as $25 for smaller balances. These payments are designed to maximize the amount of interest paid by consistently reducing the minimum monthly payment so that most of the payment goes towards interest.

For example, a $5,000 credit card at 22.25% APR, with a minimum required payment of $25 or 2.5% (whichever is higher).
The first month’s minimum payment is $125, calculated at 2.5% of the balance ($5,000 × 2.5% = $125).
Out of $125, $92.71 will go towards interest and $32.29 will reduce the balance of the debt.
After the first payment the card balance is $4,967.71. 

When the monthly minimum is calculated for the second month, it is based on 2.5% of the new balance, which is $124.19. The monthly interest accrual on $4,967.71 comes out to roughly $92.11 meaning only $32.08 is applied to principal. This cycle repeats itself, continually reducing the minimum due. This significantly increases the length of the repayment period and total interest cost of the debt.

To illustrate, we will look at a few potential repayment scenarios: