I’ve been spending a bit of time lately discussing credit cards and debt because it’s an important issue for many people. Unlike a lot of bloggers I’m not against credit cards completely. They are a financial tool just like any other. They can be a powerful tool when used correctly, but they can also cause you harm if used incorrectly. The problem is that credit cards are designed for failure by default. The features that are built into a card such as high interest rates and low minimum payments mean that even if you make all of your minimum payments on time you’ll still be doing more harm than good.
What happens with many people who get in over their head with credit card debt is they underestimate the impact that making the minimum payment each month has. Think about it. If you borrow $1,000 and your monthly minimum payment is just $25 it’s easy to write that off as an insignificant payment that you can easily afford. This way of thinking is extremely dangerous because it usually leads to racking up more debt and then spending the next ten years paying a ton of interest. So to really get ahead in the debt game you need to break the minimum payment mindset.
Understanding How Minimum Payments Are Calculated
Each card is different, but generally the minimum payment is simply a set percentage of your balance. Some cards are as low as finance charges plus 1% while others may base the minimum amount upwards of 4-5% of the balance. What you have to realize is that with a typical credit card APR the minimum payment will generally cover only a little more than that month’s finance charges, meaning at best only half of your payment is going towards paying down the balance.
For a very simplistic example, let’s take a look at a credit card balance of $1,000 with an APR of 18%. If you break the APR down to a monthly rate you are effectively being assessed a finance charge on the balance of 1.5% per month. Lets also assume that the minimum payment is calculated by using 2.5% of the balance.
This means your minimum payment in the first month is $25, or $1,000 x 2.5%. With the APR at 18% and an effective finance charge of 1.5% that means of that $25 you paid, $15 is simply paying the finance charge leaving only $10 actually applied to the balance.
So the next month your remaining balance is $990, or $1,000 – $10. Your next minimum payment is $24.75. For this payment you will see $14.85 going towards the finance charge and only $9.90 going towards the balance. Your new balance is now $980.10. You have sent the credit card company nearly $50 of your hard earned money and have only reduced your balance by $19.90. That is quite a raw deal for you, but a great deal for the credit card company.
Using this example if you continue to only make the minimum payments for the life of the balance it would take you 153 months or 12 years and 9 months to pay off the card and you will have paid $1,115.41 in interest; even more than the original amount you borrowed! (Of course this assumes the company allows small payments. In some cases they will impose a $10 minimum payment even if the calculated minimum is less than that)
Don’t Get Caught in the Payment Mindset
Today you can get financing for almost anything, from the cheapest electronics to new furniture for your house. All too often we are lured in by commercials that state how low your monthly payments can be. When you look at purchases as monthly payments as opposed to what they really cost you are setting yourself up for a very long payment plan and significant additional costs in the way of interest.
Even if you do use credit responsibly you can still fall into this trap. I see people who have the money available to pay more than the minimum amount each month but they don’t. They want to keep the cash flow available for other things. They end up treating this minimum payment as simply a monthly bill and find themselves just budgeting for it. Once this becomes habit you may find yourself paying the minimum for a long time without realizing how much it is actually costing you.
Try to Pay More Even if it is Only a Small Amount
Understandably, times can get rough and your only option may be to pay the minimum. That’s ok, just try not to make it the norm. Get into the habit of sending a bit more than the minimum each month. If your minimum payment is $25, try sending in $40. If it is $100, send in $150 or something. It may not seem like it makes much of a difference but it does over the course of time. Just applying an extra $20 to a $25 monthly payment can cut the length of time it takes to pay off the balance by more than half and potentially save you hundreds or even thousands in interest.
Clearly it would be ideal to pay the balance in full every month but that simply isn’t possible for many people. By taking baby steps and applying a little extra it will help. It won’t be instant gratification but doing so can shave years off of the repayment and save literally thousands in unnecessary interest. Remember, just because they give you a minimum amount doesn’t mean you should pay them that amount. Doing so will only cost you far more in the long run.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.