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Don’t Get Sucked Into the Minimum Payment Trap!

By JLP | December 5, 2006

Credit card companies LOVE the minimum payment. Why? Because a customer who pays the minimum payment on their credit card bill will likely NEVER (or almost never) pay off the balance, which means more interest for the credit card company.

How does the minimum payment work?

The minimum payment is usually 2% (there’s talk of it moving up to 4% but I haven’t seen that happen yet) of the outstanding balance. So, if you have a credit card with a $5,000 balance, your minimum payment would be $100. As long as you didn’t charge anything else to this credit card and you paid your bill on time, your balance would go down by the payment amount minus any interest charges for that month. So, the next month your minimum payment would be 2% of the remaining balance, which means it would be a smaller payment. The problem with this, as I stated above, is that a smaller payment means it will take longer for you to pay off your bill, which means you will pay more interest to the credit card company. To illustrate, take a look at a couple of scenarios:

Scenario 1

Beginning Balance of $5,000
Annual Interest Rate of 12%
Minimum payment percentage of 2% of the outstanding balance
Interest is calculated once per month (to keep things simple), making the periodic interest 1% (12% &#247 12 = 1%)
Nothing else is ever charged on this card

Take a look at what happens at the end of five years:

Paying the Minimum Payment on a Credit Card

Assuming all the information above, at the end of five years you would still owe over $2,700 on this credit card if you only paid the minimum payment each month. What’s worse, your TOTAL payments over those five years are only about $500 shy of your beginning balance, illustrating just how expensive interest can be.

Scenario 2

Beginning Balance of $5,000
Annual Interest Rate of 12%
Payment is a CONSTANT $100 per month
Interest is calculated once per month (to keep things simple), making the periodic interest 1% (12% &#247 12 = 1%)
Nothing else is ever charged on this card

Now take a look at what happens at the end of five years:

Paying $100 Per Month on a Credit Card

WOW! See what a difference it makes? Over the five years you would have paid $1,472 more in payments but you owe $1,819 LESS! That’s a pretty nice trade-off if you ask me. Sure it’s nice to get that credit card statement and see that you only have to pay a certain amount. However, that minimum payment comes at a very high cost!

The point of all this? Don’t fall for the minimum payment trick. Instead, pay as much as you can, as often as you can. You’ll be happy you did.

Topics: Credit, Credit Cards, Financial Math Basics | 7 Comments »

7 Responses to “Don’t Get Sucked Into the Minimum Payment Trap!”

  1. Matt Says:
    December 6th, 2006 at 11:29 am

    I’ve seen what you wrote about in practice myself. My balance almost never seemed to go down because after the interest payments I would only be paying 20-30$ down.

    I’ve gone to a steady $125 per pay accelerating the reduction, this worked really well and I got used to the money leaving right when I got paid.

  2. Steve Says:
    December 6th, 2006 at 3:05 pm

    We have a second checking account that’s just for bills and a portion of each of our checks automatically goes into it. We’ve decided how much we want to pay towards our credit card debt each month and we keep that constant, no matter the minimum payment (paying off the highest balance first).

    The point is that by making it automatic we really don’t miss it!

  3. Says:
    December 9th, 2006 at 11:27 pm

    Weekly Roundup – 12/08/06

    Here’s a quick look at some of the personal finance articles that caught my eye over the past week.

    JLP warns against getting sucked into the minimum payment trap.
    Flexo has a rundown of rebate credit cards.
    MBH sold his soul (and his phone num…

  4. AllFinancialMatters » Blog Archive » How Two-Cycle Billing Works Says:
    December 12th, 2006 at 3:11 pm

    […] It’s best not to carry a credit card balance at all. However, if that’s not possible, consider using a credit card that doesn’t utilize two-cycle billing (in other words, avoid Discover). Finally, avoid paying just the minimum payment. Bookmark to:   [link] […]

  5. AllFinancialMatters » Blog Archive » Dave Ramsey’s Snowball Method vs. Suze Orman’s Method for Getting Out of Debt Says:
    February 20th, 2007 at 7:56 pm

    […] Suze’s method makes the most sense mathematically since you are concentrating on the card that is costing you the most. And, once you get that card paid off, you can start on the next card. I also like the fact that you are paying MORE than the minimum payment each month, which is pretty much ignored with Dave’s Snowball Method. […]

  6. jonezy Says:
    November 20th, 2009 at 1:47 pm

    can we pay the minimum balance on some of the payments?

  7. i♥boys Says:
    March 4th, 2010 at 12:44 pm

    i kinda lyk boys