Why Credit Card Minimum Payments Are Dangerous
If you have a credit card balance of $500 and make the minimum payment of $20 each month, how long do you think it would take to pay off the full balance?
Here’s a hint: the answer is not 25 months. The reason? Interest.
When making a minimum monthly payment of $20 at an interest rate of 18%, it would take 32 months to pay off that $500 balance because you would have also accrued interest charges of $131. If the rate were 25%, it would take 36 months and cost $214 in interest.
A minimum payment is the smallest amount of your credit card balance that you can pay each month to avoid paying late fees and damaging your credit history. But minimum payments are also how many people end up in deeper and deeper in credit card debt. Minimum payments still require you to pay interest on the outstanding balance. Unlike term loans, such as a mortgage or student loan, credit card debt has no set repayment date. The longer you carry a balance, the more credit card companies can charge you interest. That moral dilemma is why credit card companies are perfectly fine when you pay just your minimum balance – and why you shouldn’t be.
To avoid paying interest, your best strategy should be to pay down your outstanding credit card balance in full each month if you can, and if you can’t, just make as a big a dent in your balance as you can each month. The faster you chip away at it, the less interest you’ll be throwing away.
Based on the latest data from the Federal Reserve, the average credit card balance of an indebted household is roughly $15,863. The mean credit card annual percentage rate, based on a database of over 200 cards, is approximately 17%.
With these types of numbers, if you only make the minimum payments, it will take well over a decade to pay off the balance, and your total cost would more than double from the interest charges. So, how can you avoid running into a difficult financial situation in the future?
Here are some thoughts…
Avoid Carrying a Balance
Try to stick with this rule: don’t charge anything to your card that you don’t think you can pay for at the end of the month. If you start to make small exceptions, be careful. Given that the payments won’t occur till a future date, it’s easier to overlook the costs until they’ve grown to a much larger amount. Make sure you understand how much it will cost you and how long it will take to pay off – that $250 flight might cost you closer to $400 if you’re not careful.
Consider Balance Transfer Credit Cards
If your current card accrues interest, you may be able to move your debt to a zero-interest balance transfer credit card, which could save you some money. These cards allow for you to pay off debt interest- free for a period of time in some cases as long as 21 months.
Do the Math
If you’re curious to know how long it would take to pay off your balance by just paying your minimums, find out! Run the numbers and get a sense for the timeline you could potentially face. Don’t worry – you don’t need to get out a calculator or open Excel – there are various online calculators, such as this one from Credit Karma, that will do it for you. Pay special attention to how much less in interest you will pay once you increase your monthly payment beyond the minimum.
Be Aware of Regulatory Changes
As rules change, it’s good to keep up with the latest developments, especially if they relate to credit card payments. A recent announcement stated that starting June 25th, 2016, a new set of guidelines will be in place for getting a mortgage through Fannie Mae. One update relates to “trended credit data,” which will be used to evaluate a borrower’s ability. Trended credit data actually includes whether you make the minimum monthly payment each month and if so, it will deem you as a borrower of higher risk. Hidden pitfalls like these are just one more reminder of the risk and danger of making just your minimum payment.
While it may take some steps to become financially disciplined, the good news is that many have made small changes to get there. If you cannot make more than the minimum today, plan some changes that can help you pay a bit more over time. Remember that while minimum payments seem like a good way to avoid the immediate expense, they actually lengthen the amount of time it will take you to repay your original balance and cost you extra in interest charges. If you can, try to avoid the minimum payment trap.