What you need to know about Debt and Compound Interest

What you need to know about debt and compound interest is essentially the extent to which the latter can significantly add to the former. If debt is allowed to accumulate to a significant level, it could effectively be virtually only the interest on same which the individual is paying back each month.

Compound interest is the type of interest where interest is not only charged on the outstanding debt but on the interest which has previously been applied to same. For example, if a person has a debt of one hundred dollars and the interest applied to it at the end of the first month is two dollars, the interest they will be charged at the end of the second month will be calculated not on the original one hundred dollars but on the one hundred and two dollars and therefore will be slightly more than two dollars.

The example above is very simplistic and uses very low figures but the extra debt which can be accumulated as a result of compound interest can be quite horrific. It is imperative that people recognise this about debt and compound interest and do not fall in to a trap from which it can be very hard to get out.

All types of credit cards will use this type of interest. When a credit card company calculates the minimum payment required to be made by the customer each month to their account, it will very often account only for the interest applied and a minimal portion of the outstanding debt. If the account holder is continuing to use the card but essentially paying off only a tiny amount of the mounting debt capital, their balance will rise very steeply.

Overdrafts provide an even bigger danger in relation to compound interest and debt. While at least with a credit card, a minimum monthly payment is required to be made, this is not always the case with overdrafts. If the overdraft is for a long or open ended term and the account holder is constantly using more and more of it, their outstanding debt and the interest they are charged will both be mounting each month. Even where a one hundred dollar overdraft is utilised but not paid back for several months, the interest being charged upon it will mount each month, as in the example earlier in this article.

Consumers should therefore be aware that compound interest is a way in which debt can rise to the extent where it becomes extremely difficult to service and that the true cost of borrowing money can very often be a lot higher than they were initially led to believe.