Compound interest is often called the eighth wonder of the world when it works in your favour as a saver or investor. When it works against you as a borrower — as it does on credit card debt, payday loans, and other high-rate borrowing — it can feel more like a trap.
The principle is simple. When you borrow money, you owe interest on the principal. If you do not pay that interest, it is added to the amount you owe. Next period, you owe interest on the original principal plus the accumulated unpaid interest. Interest accrues on interest. This is compounding — and it means debt grows exponentially if left unpaid.
Consider a £2,000 credit card balance at 25% APR. If you make no payments, after one year you owe £2,500. After two years, £3,125. After five years, over £6,100. The debt has tripled in five years without borrowing another penny. This is why minimum monthly payments on credit cards — which are deliberately set very low — can keep borrowers paying interest for decades without meaningfully reducing their balance.
The speed of compounding depends on two factors: the interest rate and the frequency of compounding. Credit cards in the UK typically compound interest daily, meaning interest accrues on interest every single day. At high rates with daily compounding, debt grows very fast indeed.
Payday loans — short-term, high-cost borrowing — are perhaps the most damaging form of compound interest for borrowers. Annual percentage rates of 1,000-5,000% are not unusual. A two-week loan that rolls over repeatedly can generate an enormous debt from a small original borrowing.
The lessons are clear: high-interest debt should be treated as an emergency. Pay it off aggressively, starting with the highest rate debt first (the avalanche method). Never borrow at high rates for consumption. And always calculate the total cost of borrowing, not just the monthly payment.