How Credit Card Minimum Payments can Trap You
When your credit card statement arrives each month, you’ll see two important figures – the outstanding balance on your card and the minimum amount you are required to pay. The best course of action is to pay your balance in full, every month, but that is not always possible.
A second alternative is to pay the minimum payment, which is usually much, much smaller than your outstanding bill. The actual amount of the minimum payment is set by your credit card company, so take a look at your contract for your specific details, but it is generally about 2% or 3% of your total outstanding balance.
It might seem like a good plan to use your credit cards, increase the outstanding balance every month, and then make the minimum payment at the end of the month. However, taking this approach can trap you into a vicious cycle of debt that is very difficult to escape, leading you to seek debt relief in the future.
Before we explain how minimum payments can trap you, it is important to understand how they work. Once you understand minimum payments, you can determine whether you can afford to beat them or whether you should pursue another debt relief option.
Minimum Payments by the Numbers: An Example
Minimum payments are applied to your debt in the following order: first, to pay interest, then to pay fees and, lastly, to pay down the principal.
Let’s take a look at an example of someone who owes $10,000 and is making the minimum payment on his credit card every month.
In our example, the credit card has a balance of $10,000 and a 20% annual interest rate. For this particular card, the minimum payment is 3% of the outstanding balance. For the first month, this would be $300. However, how long do you think it would take to pay off this $10,000 amount, paying just the minimum payment each month? The answer might shock you – it would take 61 years and would cost a total of over $45,000 in interest (that’s in addition to the original balance of $10,000!) to pay down this debt.
If you want to run your own calculation on your own debt, a great resource is Creditcards.com. On this site, you can input all of your figures and determine the length of time it would take to pay off your debt making just the minimum payments as well as the additional amount you’d pay in interest.
What if Your Credit Card’s Interest Rate is Zero?
Beware: You can still get trapped.
Occasionally, you might come across an introductory offer for a card where you can transfer an outstanding balance of an existing card onto this new card which has a 0% APR.
In addition to the balance transfer fees, which usually accompany these transfers and which could end up being quite high and quite costly, this introductory, 0% interest rate will only last a short period of time.
While you won’t accrue any interest during this introductory period, it’s still not a great idea to get into the habit of only making minimum payments, even on a 0% interest rate card. If you do this, you might fall into the habit of relying on minimum payments and continue doing so, even when the interest rate increases back up to double digits.
Are Payments in Full or Minimum Payments Your only Two Options?
Although often overlooked, there is actually a third option that can help you pay off your credit card debt sooner than making just the minimum payment. This option allows you to make additional payments of something in between the minimum and the full balance at any time or even multiple times a month.
For example, even making a payment of just $100 or $200 more a month (in addition to your minimum payment) will drastically cut down the amount of interest you owe and reduce the amount of time it will take to pay the balance in full.
Empowering Yourself with Knowledge
Understanding minimum payments and how they can trap you into paying much more in interest and taking much, much longer to pay off the principal balance is a great first step in getting a handle on your debt. Once you understand this, you might decide (as in our example of the $10,000 balance above) that 61 years is far too long to remain mired in debt and as such, another form of debt relief is a better option.