Compound Interest
Compound Interest is the process by which interest is calculated not only on the initial principal amount but also on any interest that has been added to that principal over time. This is evaluated within APR, Interest & Fees.
Plain-Language Meaning
Compound interest means that interest charges build upon themselves, so you end up paying interest on both your original balance and on any previously accumulated interest.
Practical Example
If you carry a balance on your credit card from month to month, you pay interest on your original balance plus any interest that was added in previous months, causing your debt to grow faster than with simple interest.
What It Does Not Mean
Compound interest does not refer to a one-time interest charge or to interest that is only calculated on the original amount borrowed or deposited.
How the System Uses It
The system calculates compound interest by applying the interest rate to both the outstanding principal and any previously accrued interest, typically on a daily or monthly basis, which increases the total amount owed over time if balances are not paid in full.
Common Misconceptions
- “Compound interest only applies to savings accounts.” Compound interest is also used in credit products like credit cards, where it increases the amount owed.
- “Compound interest is always beneficial.” While it can help savings grow, it can also make debt more expensive when applied to loans or credit cards.
- “Interest is only charged on the original amount borrowed.” With compound interest, interest is charged on both the original amount and any previously accrued interest.
Related Pages
Related Glossary Terms
FAQ
- How often is compound interest applied to credit card balances? Compound interest on credit card balances is typically calculated daily and added to the account monthly, but the exact frequency can vary by issuer.
- Can compound interest make my credit card debt grow faster? Yes, because interest is charged on both your original balance and any previously added interest, your debt can increase more quickly if you do not pay off your balance in full.