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Why Paying the Minimum Amount Due on a Credit Card Doesn’t Work

I don’t read Cracked.com(likely NSFW) for financial information. Or really for anything but amusement. It’s like Mad Magazine if most of the stuff were true and you could easily tell which parts were humorous falsification. However when I popped over there recently looking for a laugh, I found an excellent and sobering graphic about credit card interest rates that’s all true. Mostly.

You can read the whole page here, or you can view the pretty-much-safe-for-work graphic here.

The gist of the article is that if your card is one of the many which carry 24.99% interest rates and if you currently have $10,679 in credit card debt (the average American credit card debt) or more and never accrue any more debt, you will never pay it off while paying the 2% (often-used) minimum payment. In fact, your debt will grow.

Most debts you can get into are fixed and therefore have a payback plan. Your monthly payment is based on getting the debt paid back within a certain timeframe. However, credit cards are meant to be revolving so that you can always take out more or pay back more. And because the line of credit is open, there’s no plan for you to pay back in any time frame.

Fortunately, if your credit card’s interest rate is lower or you have less debt, you may be able to pay off the debt while making the minimums. But even then, you’re going to pay a LOT in interest. Bankrate’s minimum payment calculator demonstrates this.

Suppose we start with only $5,000 on a credit card, no new purchases, 18% APR, and a minimum payment of 2%. According to the calculator, by paying the minimums it would take you 472 months to be rid of your debt. In that time, you would pay $13,396.73 in interest. I would put that in a chart, but 472 months of payments would make this post extremely long. You can run the calculation yourself to see how it looks.

If, on the other hand, you started with the first month’s minimum payment, $100, and paid that every month, it would take you 94 months to be rid of your debt. In that time, you would pay $4,311.18 in interest. That’s 1/3 of the interest and less than 1/4 of the time, plus the interest is less than the principal.

If you try running the minimum payment scenario Cracked used, Bankrate throws an error and tells you that the minimum payment will never pay off the debt.

Looking at how much interest you would pay, you can see why the credit card companies have no motivation to raise the minimum payment. They’ll make their money back several times over. And really, it’s not their job to make the minimum payment larger. The minimum payment is to make sure that you pay them the money you borrowed and therefore owe them. And it’s to make sure that they get something back each month.

They’re not working with your interests in mind because that’s not their job. It’s your job to use one of these free and easily available credit card interest calculators (I highly-recommend Bankrate’s based on years of using them) to find out how much you’d spend in interest paying them back and to decide how you’re going to pay it off faster. Bankrate lets you run fixed-payment scenarios on the same debt to see how much faster you could pay it off. Studies show that the minimum payment printed influences what people pay, but don’t be fooled—it’s the minimum payment for their interests, not yours.

Paying off $5,000 shouldn’t cost you over $18,000. Do your own research, take charge of the financial decisions you’ve made, and, to quote Cracked, “for the love of God pay more than the freaking minimum!”


{ 3 comments… read them below or add one }

Ken February 22, 2010 at 6:08 am

I say it this way about banks: Their interest is in your interest. Good post.

Mama Geek February 22, 2010 at 8:19 am

The only times anyone should pay only the minimum is if they’re trying to pay down another debt with higher interest first or if they’ve been laid off and are just trying to tread water while they find something else.
.-= Mama Geek´s last blog ..Personal Finance Is Still Boring =-.

RainyDaySaver February 22, 2010 at 2:05 pm

Excellent post. It drives me nuts when people only pay the minimums (without a good reason, such as paying down other debt, as Mama Geek mentioned). When we got married, I found out my hubby was paying a bit more than the minimum on his CCs — he didn’t realize the interest implications. Now, we’re almost all paid off.

One thing the new credit card legislation has done is forced CC companies to show on customers’ statements how long it would take to pay off that debt with just minimum payments, plus how much interest would be paid. Maybe it will be an eye-opener for some folks!
.-= RainyDaySaver´s last blog ..Do You Have to Give Up Convenience in Order to Save Money? =-.

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