The problem of credit card debt is quite literally compounded by compound interest. The longer you borrow for, the quicker your debts will grow.
Debt can quickly mount up, even if you make the minimum payment each month: that simply pays off the interest on the debt, but doesn’t reduce the capital.
Compounding means the debt grows more and more quickly, because you don’t just pay interest on the money you originally borrowed on your credit card - you are also paying interest on the interest already accrued. That is to say, the amount you owe for interest one month is then added to the total amount you owe, until you clear the entire debt.
Most cards offer a 56-day interest-free period in which to pay your bill off in full. But if you don’t, interest is usually backdated to the date of purchase.
So you could end up paying more in interest over time than you originally paid for those luxury items you just had to buy on the never-never.
Most UAE credit cards carry an interest rate of 2.83 per cent per month - 39.78 per cent a year.
Borrow Dh20,000 dirhams at that rate over five years, without making any repayments, and you’d owe almost Dh107,000, with the balance effectively doubling every two years.
Interest Total
Year 1 7,956 27,956
Year 2 11,121 39,077
Year 3 15,545 54,622
Year 4 21,729 76,350
Year 5 30,372 106,722
Remember that, as interest is calculated monthly (and the behind-the-scenes bank calculations normally use a daily periodic rate which looks at the average daily account balance and the number of days in a month), this is just a rough guide.
If you search for loan repayment calculators online, you will find several to help you calculate your total repayments and interest.
For those of you interested in the maths, the calculation is PV*(1+R)^N (present value x (1 + annual interest rate) to the power of the number of periods).
In countries such as the UK, by law minimum repayments now have to be at least one per cent of your balance plus interest - reducing the compounding effect of interest being paid on interest.
Even if you were to make that minimum repayment on the same Dh20,000 (at Dh798 per month), it would still take you 47 months to pay off the debt and you would pay Dh37,482 in total.
As Albert Einstein said: “The most powerful force in the universe is compound interest.”
pf@thenational.ae