Compound interest is a concept related to the accumulation of interest on both the initial principal amount and any previously accumulated interest. When a revolving credit balance or service credit balance is not paid by the due date, interest is charged on the unpaid amount.
To understand the impact of compound interest, let's consider an example. Let's say you have a credit card balance of $1,000 and the annual interest rate on the credit card is 10%. If you don't make any payments and let the balance carry over to the end of the month, the interest will start to accumulate.
Here's how the calculation works:
1. Determine the monthly interest rate: Divide the annual interest rate by 12 months. In this case, 10% divided by 12 gives us a monthly interest rate of approximately 0.83%.
2. Calculate the interest for the first month: Multiply the monthly interest rate by the initial balance of $1,000. This gives us an interest charge of approximately $8.33.
3. Add the interest to the balance: The new balance after one month will be the initial balance ($1,000) plus the interest charge ($8.33), resulting in a total balance of approximately $1,008.33.
4. Repeat the process for subsequent months: For each month that the balance remains unpaid, the interest will continue to compound. You would need to calculate the interest on the new balance each month and add it to the total balance.
It's important to note that this is a simplified example, and in reality, credit cards may have different interest calculation methods and additional fees. The example demonstrates how compound interest can increase the amount owed if a credit card balance is not paid off promptly.
In summary, compound interest refers to the accumulation of interest on the initial principal amount and any previously accumulated interest. When a credit balance is not paid, interest charges can compound over time, leading to a larger amount owed.