Compound Interest Explained

You may have heard compound interest called the “eighth wonder of the world.” When it’s working for you — in a savings account or investment — it helps your money grow faster over time. But when you’re in debt, compound interest flips to the other side and works against you, making your balance grow in the same relentless way. Understanding how it works is the first step to fighting back.

Simple Interest vs Compound Interest: A Quick Refresher

With simple interest, you only pay interest on the original amount you borrowed (the principal). The interest charge stays the same every period.

With compound interest, you pay interest on your principal and on any interest that’s already been added to your balance. Each period, your balance grows a little bigger, and then interest is calculated on that bigger number. It’s interest on interest.

Most credit cards, many student loans, and some personal loans use compound interest. That’s why they can feel so hard to pay off.

How Compounding Works: A Step-by-Step Example

Let’s say you have a $5,000 credit card balance at 20% APR, compounded monthly. You’re making no payments (just to show how compounding works on its own).

• Monthly interest rate: 20% / 12 = 1.667%
• Month 1: $5,000 x 1.667% = $83.33 in interest. New balance: $5,083.33
• Month 2: $5,083.33 x 1.667% = $84.72 in interest. New balance: $5,168.05
• Month 3: $5,168.05 x 1.667% = $86.13 in interest. New balance: $5,254.18

Notice how the interest charge grows each month? That’s compounding in action. By month 3, you’re paying $86.13 in interest instead of $83.33 — and that gap keeps widening.

After one full year with no payments, that $5,000 balance would grow to approximately $6,098. You’d owe over $1,000 more than what you originally charged, without buying a single new thing.

The Long-Term Impact

Compounding really shows its teeth over longer time periods. Let’s look at what happens to a $10,000 credit card balance at 22% APR if you only make minimum payments (starting at 2% of the balance, with a $25 floor):

• Total amount you’d pay: approximately $28,700
• Total interest paid: approximately $18,700
• Time to pay off: roughly 30 years

You’d pay nearly triple the original balance. That’s the cost of compounding combined with minimum payments. The interest keeps piling on top of itself, month after month, year after year.

Why Minimum Payments Keep You Stuck

Minimum payments are designed to be low enough that you can always afford them. But that’s also what makes them dangerous. In the early years, most of your minimum payment goes toward interest — not your balance.

Here’s what a typical month might look like on a $5,000 balance at 20% APR:

• Minimum payment: $100
• Interest charged: $83
• Amount going to your balance: $17

Only $17 out of that $100 payment actually reduces what you owe. The rest covers the interest that compounded since your last payment. As your balance slowly drops, more of your payment goes toward principal — but it takes years for that shift to become meaningful.

Compounding Frequency Matters

How often interest compounds makes a difference. Common compounding frequencies include:

• Daily — most credit cards compound daily, which means interest is calculated on your balance every single day
• Monthly — many loans compound monthly
• Annually — some student loans and personal loans compound yearly

Daily compounding costs you more than monthly compounding, which costs more than annual compounding. The more frequently interest is calculated and added to your balance, the faster your debt grows.

For credit cards with daily compounding, the formula uses your daily periodic rate (APR / 365). Even though the daily amount seems tiny, it adds up quickly over 30 days.

How to Fight Back Against Compounding

The good news is that compounding works both ways. Just as it accelerates your debt growth, paying more than the minimum accelerates your payoff. Here’s how:

• Pay more than the minimum. Even an extra $50 per month on a $5,000 balance at 20% APR can save you thousands in interest and cut your payoff time by years.
• Make payments more frequently. Paying every two weeks instead of once a month reduces the average daily balance that interest is calculated on.
• Target high-rate debts first. The avalanche method — paying the most toward your highest-interest debt — minimizes the total compounding you face.
• Look into lower-rate options. A balance transfer or consolidation loan at a lower rate reduces how fast interest compounds.

A More Hopeful Way to Look at It

Once you start making real progress on your debt, compounding works less aggressively against you. As your balance drops, the amount of interest charged each month drops too. The further you go, the faster you go.

Think of it like pushing a boulder uphill. The beginning is the hardest part — most of your payment covers interest. But as the balance gets smaller, more of every payment chips away at the principal, and momentum builds in your favor.

Bottom Line

Compound interest charges you interest on your interest, making debt grow faster the longer you carry it. Minimum payments barely keep up with compounding, which is why debts can take decades to pay off. The best defense is paying more than the minimum, targeting high-interest debts first, and reducing your rates where possible. Every extra dollar you pay disrupts the compounding cycle and brings you closer to debt-free.