Paul Lewis

The banks get rich because they are better at arithmetic than us. Especially compound interest. Which has been called the eighth wonder of the world. Consider this. You owe £1000 on a credit card. The interest rate is a typical 17.9% APR. And the minimum repayment is 2.25% of the debt or £5 whichever is the greater. If you spend nothing else on the card and only make the minimum payment each month, how long does it take to repay that debt?

If you said much less than twenty years then you are wrong. In fact it is nineteen years nine months before the debt is paid. In other words the spring flowers would be blooming in 2029 before you are free from it. And you would have paid £1339 in interest, which is rather more than the original loan.

There are two reasons the debt lasts so long. Out of your first monthly payment of £22.81 only £8.96 comes off your debt. The other £13.85 is interest. So the next month you are paying interest on the interest that was added the previous month. And so on. That is compound interest.

Second, the monthly repayment is a fixed percentage of what you still owe. As the debt slowly diminishes so does the monthly payment. Only when it falls to £5 (at the start of 2023) does it stick at that amount and then the debt swiftly disappears. Without that rule it would take more than a century to pay off.

There is a simple way to get rid of your debt within a human lifetime! Instead of letting the monthly payment diminish each month, you fix it at that initial amount of £22.81. If you can afford that much this month then you can afford it every month. If you do that the debt will be cleared in 5 years 8 months, while the weather is still chilly in early 2015. And if you can afford to double that payment to £45.62 a month then the debt goes in little more than two years, by the autumn of 2011.

Card companies normally offer customers only two options – pay the debt in full each month which about half of us do. And pay the minimum. They never offer a fixed amount to repay. To get that you have to phone and make a special arrangement. But that one call can save you a fortune. All thanks to cutting out the compound interest.

Written by Paul Lewis, May 2009. Paul is the editor of Saga Magazine's Money News section. Paul's opinions are his own and for general information only. Always seek independent financial advice.