What is Credit Card Compound Interest?

When it comes to using credit wisely, one of the best things you can do as a credit cardholder is to avoid accruing compound interest on large credit card balances. Interest is essentially how much will be charged to your account above and beyond your credit balance. Interest can be calculated on a daily, monthly, quarterly, or annual basis. Most credit cards charge interest using a daily period interest rate, adding the interest to your account balance every day.

If your credit card company uses a periodic rate that is compounded on a monthly basis, interest will be added to your credit balance one each month. For example, if your account balance is $100 and you make a $10 payment, you will be charged interest for the month on the remaining $90. If your credit card's monthly periodic interest rate is two percent, the following month's bill will include an additional $1.80 in finance charges ($90 x 2 percent = $1.80).

It’s easy to see how compound interest can add up to a significant credit card expense if you carry a balance because you will be paying more and more every month in interest unless you are able to pay down the amount you owe. Of course, if you pay your credit balance in full every month, you never need worry about the periodic or compound interest rate.

When is credit card compound interest acceptable?

Some consumers are willing to pay compound interest under certain circumstances, particularly if your credit card company gives you a reasonable interest rate. For example, it may be worthwhile when you are buying furniture for a new home even though you won't be able to pay for it for several months. Many people would prefer to pay compound interest for a few months in order to have the furniture when they move in.

Credit card compound interest instead of a loan

College students and small business owners are often among those who use credit cards in place of bank loans. Although the interest rates are typically higher than loans (thus, so is the compound interest), qualifying for a credit card may be easier than getting approved for a loan.

If you avoid maxing out your card and make your monthly payments on time, you can still build good credit while carrying a monthly balance. Just shop around for a credit card with a low APR so your compound interest doesn't get out of hand.