One of the most costly mistakes you can make with credit cards is getting into the habit of only paying the minimum amount due each month. While the minimum amount may be affordable; it will also cost you more money in the long run.
How the Minimum Payment is Calculated
To better understand why paying the minimum can be so costly it is important to learn how the minimum payment is calculated. While each card can use a different calculation they all use a certain percentage of the balance as a primary factor. This could be as low as the finance charges for that period plus 1% or upwards of 4-5% of the balance. Make sure you check your credit cards to determine how the payment is calculated.
For an example let’s take a look at a credit card with a balance of $1,000 that has an APR of 18%. When you break the APR down to twelve monthly periods you end up with a 1.5% finance charge per month. For this example we will also use the assumption that the card calculates the minimum payment by 2.5% of the balance.
This means your minimum payment in the first month is $25, or $1,000 x 2.5%. With the card’s APR of 18% or 1.5% per month that means of that $25 payment only $10 is being applied to the balance while the other $15 is paying that month’s finance charge. During the next month your remaining balance is now $990 so your next minimum payment would be calculated as $24.75 ($990 x 2.5%). For this payment $14.85 covers that month’s finance charge while $9.90 is applied to the balance.
As you can see above, you have made almost $50 in payments yet only reduced your balance by $19.90. If you were to continue paying only the minimum and the features of this card remained unchanged it would take 153 months or almost 13 years to pay off a $1,000 initial balance. This would result in paying $1,115.41 on just interest alone, more than the amount of the original balance!
Putting the Plan Into Action
It is easy to get into the habit of making only the minimum payments. They are low and it can free up cash flow for other areas of your finances. Unfortunately, paying the minimum can be very costly as demonstrated above. Even a very low balance can cost you more in interest and take over a decade to repay. Compound this problem with multiple credit cards and higher balances and you can see why it can be so difficult to get out of debt.
To combat this problem, you need to find a way to pay more than the minimum each time, even if it is only a little bit extra. If the minimum payment is $40 then make an effort to send at least $50. You probably won’t notice the extra ten dollars but it will go directly onto your principal and eat away at the debt even faster.
As you can afford to do so, you should increase this extra payment. Try increasing it $10 each month until you are beginning to really put a dent in the balance. Doing this will literally shave years off the repayment period and save hundreds or even thousands of dollars.