« Check Out Ramit’s eBook! | Main | 401(k) Contribution Limits for 2007 »
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% ÷ 12 = 1%)
Nothing else is ever charged on this card
Take a look at what happens at the end of five years:
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% ÷ 12 = 1%)
Nothing else is ever charged on this card
Now take a look at what happens at the end of five years:
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 |