To some, credit cards represent everything that is evil. It’s true that credit cards have done their fair share of damage to people’s finances, but they are also a useful tool. But what makes credit cards bad for most people is the minimum payment. That’s it. High interest rates don’t help, but it’s when you are stuck paying just the minimum payment each month where the high interest rates eat you alive.
This is the trap that most people who find themselves in debt fall into. You take a simple purchase and put it on your credit card. Maybe you even have the intention of paying off the balance in full at the end of the month, but if that doesn’t happen, don’t worry. The credit card companies make it incredibly easy to keep the payment affordable and only require to make a minimum payment each month to stay current. That can certainly help your cash flow situation out, but it’s doing far more damage than you might imagine. Credit cards aren’t evil, but it’s the minimum payments that are evil.
Minimum payments are really bad because it keeps your credit utilization ratio high, which significantly impacts your credit score, see more on what is a good credit score here. To see how it is affecting you, be sure to check out my Credit Karma review and sign up for a free account.
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 simple 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! In reality, it probably wouldn’t take this long because most card companies have a flat rate minimum if the calculated minimum payment is under say $10 or $5. Even so, it would still take years to pay off a $1,000 balance if you only paid the minimum each month.
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 you.
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 finance charges. The faster you can repay the credit cards, the faster you’ll get out of debt and improve your credit score. 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.
