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People believe this myth for two main reasons: first,
they see how hard it is to pay off credit cards
and they assume this means that they are compounding
interest, and second they see that their statement
says their credit card compounds on a daily basis.
This leads some to believe that credit card interest
compounds on a daily basis. In fact, if credit card
interest were allowed to compound one would never
actually pay off credit cards. Compounding means
"to apply interest to." When interest is applied
to interest this is compound interest. With credit
cards, interest is applied to the average daily
principal balance and the interest accrues until
the end of the month. At the end of the month,
a statement is issued which has a minimum payment.
That minimum payment is always enough to cover
the accrued interest for the previous month and
a little portion of the principal owed.
In this way interest is applied to the principal
of a loan and not to the interest. Therefore,
the interest only gets to be compounded when you
don't pay the minimum payment for an entire month.
Then the interest is added to the principal and
is subject to compounding.
The question is, if credit cards don't compound
interest, then why are they so expensive? To see
the answer to this, read the article, "What Makes
Credit Cards Bad."
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