More on compound interest
For every month that goes by, 1% of the balance (12% divided by 12 months) is going to get added to the balance. The following month, that 1% is calculated on the new balance. For example, after one month, the balance would grow to $1,010. That’s $1,000 times 1%.
After another month, with no payments, the balance would grow to $1,020.10. The balance grew not by $10 like the month before, but $10.10. The difference comes from the fact that interest was calculated on the new balance, not the original. It doesn’t take long before this interest-on-interest growth of the balance mushrooms beyond control.
It’s not hard to see that with higher-interest-rate loans, this can spiral out of control. This is especially true when you are making the minimum payments, getting late fees added to your payments, or even skipping payments altogether. To add insult to injury, many companies begin raising their already-high interest rates when you don’t keep your account in good standing.
To make matters worse, most interest is compounded daily, not monthly. This only speeds up the effects of compound interest, and leaves you making much slower progress than you need.