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Why Minimum Credit Card Payments Are Not Your Friend

Accepted the world over, credit cards turn money into something magical: a plastic genie emerging from wallets and purses, bestowing purchasing power and rewards to all who swipe and sign.

In practice, the credit card has become an indispensable financial tool…but it comes with a price.

When you make a purchase with your credit card, it’s not your money; you’re "renting" money from the credit card issuer and the final cost can vary greatly. Interest rates become finance charges, which increase the principal balance. The finance charge is your "rent" — pay late and you'll incur fees.

The cheapest thing to do is pay the balance in full every month. However, your monthly statement includes a minimum payment that is far less than the full balance. What are the consequences if you just pay the smaller amount and use your cash elsewhere?

The simplest way to answer this question is to examine two scenarios. (Disclaimer: all numbers are for example only.)

Scenario 1: When less equals a lot more

Let’s say you've been enjoying a promotional 0.00% Annual Percentage Rate (APR) on your card for the last six months and it’s about to change to the standard rate. That $5,000 balance and your new 15.99% APR are about to generate some serious interest.

Minimum payments vary by card issuer; however, let’s say yours is $150. This covers the initial cost of interest ($66.63) plus $83.37 that will apply towards the principal.

Which doesn't feel too bad, especially when you notice that as your balance decreases, so does your minimum payment. Cool!

Except when you run those numbers through a credit card payoff calculator and discover that paying the minimums leaves you paying the credit card off for close to 17 years and $3,539.63 in interest. That $5,000 you borrowed will have cost you a grand total of $8,539.63. Ouch!

Scenario 2: Pay more upfront and reap the savings

Now, consider a slightly different scenario starting with the same numbers, but a more consistent payment:

$5,000 balance with a 15.99% APR and your minimum payment starts at $150. The only difference is that you keep paying $150 even when the "minimum payment" and monthly interest dwindle. This means more of each payment goes directly to the principal balance.

The result? You pay the card off in less than 4 years and pay $1,655.06 in interest — less than half the amount you paid in the other scenario — for a total cost of $6,655.06.

It’s important to consider that most people don't quit using their credit card cold turkey. So the principal balance is likely to fluctuate month to month, depending on how much you use it. This will change your minimum payment and the length of time to pay it off. If you use the card for additional purchases, it’s best to increase your payment accordingly and avoid accruing interest.

The key takeaway is this: every dollar that you can pay above the minimum will help you pay down the principal balance faster and cost you the least amount to "rent" money from the credit card company. So even if you can’t resist that cashmere sweater or big screen TV, at least it won’t cost you an arm and a leg.

Tags: Credit Cards