Why Making Minimum Payments Gets You Nowhere

By Tim Parker | July 12, 2012 AAA
Why Making Minimum Payments Gets You Nowhere

It's like running on a financial treadmill. Anybody with a credit card balance knows that making only the minimum payments takes a lot of your money but gets you nowhere. If you had a $5,000 balance on a card with an 18.9% interest rate and your minimum payment was $200 each month, it would take you 11 years and five months to pay the entire balance. By the time you make the last payment, you will have paid $8,109.
To make it even more depressing, let's say that you purchased a beautiful bedroom suite for $5,000. Once you pay the credit card balance making only the minimum payments, you will have paid 62% more for that bedroom suite while watching the value of your furniture drop with each passing year. Will you still own that furniture 11 years from now? Why does it work out to be so customer unfriendly? It's because the credit card companies employ some tricks to keep you paying more.

SEE: How Credit Card Delinquency Works

According to Bankrate.com, your minimum payment is calculated as a percentage of your total balance. This includes the interest that is added to the balance each month. In our example above, the minimum payment of $200 is based on the credit card company requiring no less than 4% of your daily balance each month. Basing it on a percentage instead of a fixed amount works in the credit card company's favor because you keep a higher balance allowing the credit card company to charge more interest. Once you pay your balance down to $2,500, your payment is now only $100. When you reach $1,000, you're only required to pay $40. What if credit cards worked like mortgages and you paid a set amount regardless of your balance? If you were to pay $200 per month until the balance was paid, it would take you 32 months instead of 137 months and you would pay nearly 50% less in total interest.

Lower Percentage
Four percent of the balance is steep, and likely too much for some people, which is why many card companies only require 2%. If you only pay 2% each month, it will take you more than 30 years to pay off the balance and you'll end up paying more than $19,000 in total payments. That makes your $5,000 bedroom suite 280% more expensive. If there was a price tag of $19,000 on the furniture, would you still have bought it?

The Best Strategy
Of course, the best strategy is to pay as much as possible in the shortest amount of time. If you have money in an investment account that isn't retirement related, pay off your credit cards before investing. Next, if you're only able to pay the minimum amount right now, continue paying the same amount as your balance decreases. Finally, if you have multiple credit cards, make minimum payments on all cards except for the card with the highest interest rate. Pay the maximum possible on that card until it's paid off. Then, go to the card with the next highest interest rate and add the amount you were paying on the last card to the current card. This will allow you to pay a higher amount on each card as one is paid off. To make it even more simple, don't decrease your total monthly credit card payment until all of your cards are paid off.

SEE: Worst Case Scenario For Credit Card Debt

The Bottom Line
Paying the minimum balance might keep your credit report in good shape, but it will do little to help pay down the balance on your credit card. Paying hundreds or thousands per year in interest is a financial emergency that you should remedy quickly. Giving up some of your non-essential spending in order to pay off the debt is the best investment you can make.

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