dcsimg
Advertiser Disclosure: Many of the savings offers appearing on this site are from advertisers from which this website receives compensation for being listed here. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). These offers do not represent all deposit accounts available.

Credit card debt: The less you pay, the more it costs

By Richard Barrington

Credit card debt: The less you pay, the more it costs

In George Orwell's "1984," the totalitarian regime often confused the populace by using contradictory phrases such as "war is peace" and "freedom is slavery." The common credit card term "minimum payment" might contain a similar sort of contradiction, because by making minimum payments, you'll find yourself shelling out the maximum amount of money.

The reason is that the longer it takes you to pay down a credit card balance, the more interest you will pay on that balance. Thus, making the minimum payment each month will mean racking up more in the way of interest charges. Just how much more may surprise you.

The true cost of minimum payments

Suppose you shell out $1,500 for a home theater system. It's a big investment, so you put it on your credit card so you can pay it off over time.

For this example, let's assume your credit card charges a minimum payment equal to the larger of 3 percent of your outstanding balance, or $10. These are fairly typical minimum payment terms.

Under those terms, if you make just the minimum payment every month (and assuming you add nothing else to your balance) it will take you over ten years to pay off that $1,500 purchase. Meanwhile, interest charges, at a fairly typical 15 percent rate, would have totaled $810.41. Thus, you would have increased the total cost of that home theater system by 54 percent, to $2,310.41.

Bringing those interest costs down

Making some simple tweaks to the minimum payment can really bring those interest costs down. For example, suppose you consistently pay 50 percent over the minimum payment. Using this approach would eliminate that $1,500 debt in just under six years, with a total interest cost of $441.90, as opposed to the $810.41 you would pay in interest by making the minimum payments.

Suppose there isn't enough room in your monthly budget for you to pay 50 percent over the minimum payment. There is another approach which will stress your budget less in the short term, but allow you to pay off your balance faster in the long term.

Under the credit card terms described above, your initial minimum payment would be $45; i.e., 3 percent of $1,500. This minimum payment would then decline slowly as your balance declines. However, assuming you can afford to pay that initial $45 minimum, suppose you keep your monthly payment at that amount in subsequent months. This way, you would keep the payment at a level you can afford, but you would be steadily paying more and more over the minimum as it starts to shrink.

The results of this approach? You would pay off your $1,500 purchase in about three and a half years, incurring just $384.44 in interest charges - less than half the interest you'd pay by sticking to the minimum payment all along.

Other factors that can jack up your credit card costs

Besides making minimum payments, there are other things that can substantially raise your interest expenses:

  • Missed payments. On many credit cards, missed payments invoke a double-whammy: a penalty fee, plus a shift to a higher interest rate going forward.
  • Poor credit. In general, the worse your credit rating, the higher the interest rate you'll pay. Remember, you can get a free FICO credit score report to check out any potential problems with your credit rating.
  • Balance transfers. Zero percent balance transfer offers sound great, but there may be an upfront fee for each transfer, and the zero percent applies for a limited time only. After that, interest rates on balance transfers are often higher than rates on purchases, so be sure to read the fine print of your credit card agreement.
  • Rewards/cash back programs. Make sure these incentives are worth it to you, because these credit cards often carry higher interest rates.

Remember, minimum payments do the opposite of minimizing your credit card costs. Larger payments, good payment and credit histories, and careful attention to credit card terms are the things that will bring those costs down.

Richard Barrington has earned the CFA designation and is a 20-year veteran of the financial industry, including having previously served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc. Richard has written extensively on investment and personal finance topics.

Feed for this Entry

Leave a Reply



If you liked this site, please Add To Bookmark and/or Subscribe To A FeedReader

Search this site