When you make a charge on your credit card, the bank that issued the card pays the vendor the amount owed and you pay back the money borrowed, in addition to interest. Interest is a percentage-based surcharge, generally between 7 percent and 36 percent, paid for the privilege of borrowing the bank's money. Compound interest arises when interest is added to the principal and that added interest earns interest.
There are two basic kinds of interest, simple and compound. Unlike compound interest, simple interest is calculated once. If you borrowed $1,000, for one month, at a rate of 2 percent interest per month, you are dealing with simple interest. To calculate simple interest, multiply the amount you borrowed by the interest rate. Thus, if you borrowed $1,000 at 2 percent interest, you would owe the lender $1,020 at the end of the month.
With compound interest, the interest owed becomes part of the principal. If you borrowed $1,000 and you're charged 2 percent per day until the end of the month, you are dealing with compound interest. At the end of the first day, you would owe $1,020. At the end of the second day, you'd owe 1,040.4 ($1,020 multiplied by 0.02 and added to $1,020). At the end of third day, you'd owe 1,061.21 ($1,040 multiplied by 0.02 and added to $1,040), and so on. If you have a high interest rate, your balance can increase exponentially as you continue to pay interest on the interest.
In the credit card context, interest rates are often presented in terms of annual percentage rate. There are two types of APR: nominal and effective. Nominal APR represents the monthly simple interest rate paid over the course of the year. Thus, a nominal APR of 24 percent amounts to 2 percent interest per month. If you borrowed $1,000 for a year, you would expect to pay an extra $240 at the end of the year, but this is not the case. Nominal APR doesn't take compounding into consideration.
Unlike nominal APR, the effective APR, a more mathematically true APR, incorporates compounding and paints a better picture of the actual amount you'll pay in interest. If the small print in your credit card bill notes the effective APR, pay close attention to this number, as it dictates the true percent of interest you'll pay over the course of a year.
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