A few weeks ago, I posted an article on the idea of interest that accrues daily. Here’s a brief explanation; check out the full post for more details:
Some banks will accrue interest daily. Some even accrue it continuously. Rest assured, the more often a bank accrues interest on your debt, the worse it is for you (on the other hand, the more often a bank accrues interest on your savings account, the better it is for you).
So, let’s look again at the $100,000 loan at 12% APR.
If interest is being accrued daily… you better break out the spreadsheet. You’ll need to divide 12% by 365, giving you 0.032876712% calculated each day. Then, you have to do the calculation described above 365 times. I’ll save you the trouble – if interest is accrued daily, you’ll end up with a balance of $112,747.46. This debt would have an APY of 12.74746%, in other words.
In other words, when interest accrues daily, you’re actually paying more interest each year than the APR tells you that you are.
Credit card companies often use daily compounding interest. Let’s take a look at how that might affect you.
Let’s say that you’re sitting on a credit card debt of $7,500 with an APR of 29.99%. Over the course of a year, this debt would accrue interest of $2,250. However, if it’s compounded daily (as credit cards are), you’ll owe $2,622.70 in interest instead. Ouch. That’s $372.70 down the tubes.
The next piece of the puzzle is how credit card bills actually work. When you receive a bill, the balance due covers the interest accrued over the past month plus a little bit of the balance. So, let’s say your debt will accumulate $50 in interest by the time of your due date. Your minimum payment might be $60, which will pay off the $50 in interest and put $10 toward your balance.
Here’s the thing, though. If the payment arrives earlier in the month, the balance is a bit different. You might only have $40 in interest outstanding, so $20 of your payment will go toward the balance instead.
Of course, that means there will be more time for the interest to build up before your next statement, but the balance won’t be quite as high, so the interest will accrue a little slower. The daily compounding still happens, but it’s not as painful as before because the balance isn’t as high.
So, how can you really take advantage of that idea?
My approach would be to pay bills every week rather than every month. This assumes, of course, that you’re paid each week. Rather than just paying your bills once a month, pay all of your bills weekly, right after they come in.
You should go further than that, too.
The next time your credit card bill comes in, pay the full minimum (or, ideally, more than that), but don’t just stop there. Each week after that, when you log onto your bank’s website to pay the bills, pay a quarter of your minimum payment. It won’t be a very big amount – probably $10 or $20 – but it will keep that interest from accumulating and building on itself. Then, when the regular bill comes in, pay the full minimum payment that week.
Just treat this extra $10 or $20 a week as a tiny extra bill. What it will do is take away much of the power of daily compounding. In the example above, it doesn’t get rid of all of the extra $370, but it gets rid of most of it. Plus, it moves you quickly along the path of paying off the debt.
Of course, the real trick is to learn how to live without the plastic at all. Good luck!