Question

One credit card's APR is 12.99%. Assume monthly compounding frequency: calculate if you have a balance of $1,000 at the beginning of the year, how much you will have (owe) on balance one month later AND 12 months later? Assume you do not borrow more and you do not repay any money or interest throughout the year.

How can this compounding effect impact the borrowers? What recommendation(s) would you make to other borrowers to minimize the negative impact?

Answer 1

Since the compounding is monthly, the monthly rate will be = 12.99/12 = 1.0825%. Hence, the balance after one month will be = 1.010825 x 1000 = 1010.825.

Similarly, after 12 months it will be = 1.010825^12 x 1000 = 1137.9

Hence, we see that because of the monthly compounding, the balance is more than what it should have been if it was yearly compounding. So, compounding can be dangerous if you have taken a debt. To minimize the impact, we woukd suggest the borrowers to pay back the amount as soon as possible.