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By: Steven Michael Vaiani on Mon Jun 2, 2008

There’s no easier way to wrap your head around debt and your relation to it than to get a basic idea of how compound interest works versus simple interest. Compound interest is that double-edged sword - boon to some, bane to others. Compound interest is what causes some loan recipients to owe substantially more than they borrowed, and some people to earn way more than they invested.

Compound interest is interest upon interest, the very machine that spurs the creation of global capital, the reason your banker wears natty suits, and why a guy named George Soros can give subtle hints to eastern European nations to get a lil' more democratic. Compound interest is a great boon when you’re saving money in retirement funds, and earning returns on returns, but when you’re paying interest, it’s trouble with a capital T.

Let’s take this example – you charge $50 on your credit card to buy a saxophone reed for your sister's graduation from the Berklee College of Music. The bill arrives shortly thereafter, and you pay the minimum amount, which is 2%, in this case, $1. Only making the minimum payments every month, it will take you 82 months and $82 to pay off a $50 reed. 82 months later, you’re not even going to remember buying that saxophone reed, and you’ll probably also be oblivious to the fact that you ended up paying $32 more than what it retailed for!

The average North American family owes more than $5,000 on their credit cards, and at 15% or 16% interest, they will be paying between $800 and $900 in interest on their principle. Had they taken the money that they spent on interest, and invested it in an investment that gave an 8% return, they would have $100,000 plus after only three years.

But if you want to be able to raise capital, you’re going to have to have some sort of credit rating, and that means that they’ll be looking at your credit report to determine the interest rates on loans, security clearance for certain jobs, whether an apartment will be rented to you. They do so by using your credit report to create a credit score, a method created by a company called Fair, Isaac & Co. (Thus, that score is referred to as an FICO score.) Nobody knows exactly how a FICO score is determined, but there are some basic principles – first, paying bills on time and not maxing out credit are important indicators that will lead to a positive and higher credit score.

Take On Your Debt

A smart approach to credit is to think of consumer debt as the most nefarious, terrible and awful thing to have about, an albatross around your neck, and you’re the Ancient Mariner. Pay it off as quickly as you possibly can – whether it’s credit card debt, auto loan debt, personal loans. Paying off consumer debt will allow you to push capital towards better areas – saving for retirement, or planning for financial disasters.

Make a list of all of your acquired debt on a sheet, and rank them according to their interest rate. The debt with the highest rate of interest you should pay off immediately, while paying minimums on the rest, and then pay off the next highest debt using the same amount you were able to afford from your budget. If you’re a customer in good standing, you can generally negotiate with your credit card company to lower your interest rates or waive the annual fees you pay on your credit cards. You should also carefully examine all your statements for fraudulent additions, incorrect charges, or any movement on the part of the credit company to change your agreement. By using the card and not objecting, you’ve given what John Stuart Mill would call tacit approval to the new fees and charges.