In this series I am covering the 24 tell-tale signs that you could be in financial trouble. Over the next few weeks I will be presenting these signs, how to identify them and tips on how to address the issue.
I don’t want to spend too much time on this one since it is fairly obvious, but if you find yourself paying only the minimum amount due on your credit card bills you are heading down a long road of almost eternal finance charges.
Understanding How Minimum Payments Are Calculated
Each card can be different, but generally speaking 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 that 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.
Ultimately, 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!
Don’t Get Caught in the Payment Mindset
Today you can get financing for 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.
Try to Pay More Even if it is Only a Little
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 much or that it makes much of a difference but it does over the course of time.
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.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.