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How the minimum payment maximizes pain

Your credit card company isn't doing you any favors by allowing you to make only a small monthly payment.

By MSN Money Partner Dec 15, 2011 9:56AM

This post comes from Rob Berger at partner blog The Dough Roller.

 

The Dough Roller on MSN MoneyThe minimum payment required on a credit card is a lot like the three Sirens of Greek mythology. Part human and part bird, the Sirens lived on a rocky island in the middle of the sea. They sang so beautifully that passing sailors couldn't resist getting closer, with disastrous results as their ships smashed into the rocks. And so it is with making just the minimum required payment on your credit card bill.

 

Imagine having a whopping $10,000 in credit card debt, but only having to pay $200 a month. The $200 is the beautiful song of the Sirens. The $10,000, and the interest you'll pay by making just the required payment, represent the rocky island. Here's how to avoid disaster.

 

How to calculate your minimum payment

Credit card companies require you to pay a very small percentage of your total balance each month. While the amount varies from one company to the next, 2% of the outstanding balance or $15, whichever is greater, is common. To calculate your monthly payment, simply multiply your total balance by the percentage your particular credit card requires you to pay each month.

 

For example, if your balance is $10,000 and your credit card company requires you to pay 2% of that total, your monthly payment will be $200 (10,000 X .02 = 200). You can use this handy calculator from Bankrate as well.

 

Why paying the minimum costs a fortune

So $200 per month on a balance that large seems like a gift. Think again. Many credit cards charge an interest rate of 15% to 18% each month. The minimum payment includes any interest you owe. As a result, any outstanding interest is deducted from your minimum payment first. What's left then goes to reduce your balance.

 

For example, if there is 15% interest on the $10,000 balance, $125 of the $200 payment goes to interest (.15 / 12 X $10,000 = 125). Only the remaining $75 is deducted from the balance. At this rate, it would take more than 35 years (424 months) to pay off the balance. And you'd end up paying more in interest than what you charged to the card in the first place. Your $10,000 balance will end up costing $25,851. The only one receiving a gift from making your minimum payment is your credit card company.

 

The table below is a snapshot of what it would look like if you paid only the minimum payment for just the first two years.

 

Credit card statements to the rescue

Thanks to new credit card regulations over the past few years, card issuers now need to provide minimum payment information in the credit card statement. This information is extremely valuable in understanding the consequences of making just the required payment.

 

You should find two items on your statement:

  • How long it will take to pay off the balance and the interest you'll pay if you make just the minimum payment.
  • How much you need to pay each month to pay off your balance in full in three years.

Recently I received a statement for my Citi Platinum Select MasterCard that had a new balance of about $3,000. Guess how long my statement indicates it will take me to pay this balance off if I stick with the minimum payment. Nineteen years! And the interest costs will total more than $7,000. To pay off the balance in three years I'd need to make monthly payments of $109. This is very useful and eye-opening information, so make sure to find it on your next credit card statement.

 

Paying a little extra makes a big difference

So you've resolved that you will shun the Siren song of the tempting but dangerous minimum payment. But you may be thinking that you only have a few extra dollars to put toward your credit card debt each month. The good news is that even a little extra each month will bring down your balance quickly, resulting in less interest.

 

For example, paying just $50 more per month on your credit card can make a huge difference. Let's say that instead of paying the minimum of $200 on the $10,000 balance, you decide to pay $250. You still pay $125 in interest in the first month, but now $125 is being deducted from the original balance. At this rate, you will pay off your balance in just under five years (56 months) and end up paying $3,949.66 in interest. That extra $50 a month equals an outrageous savings of $21,901.34 in interest and about 30 years of monthly payments. Smart consumer, 1; credit card company, 0.

 

This table shows you what your balance will look like after two years when you pay just 50 extra dollars a month.

 

 

So, the next time you open that statement and think your card company has done you a favor with a low minimum payment, tune out the music and work an affordable extra payment into your budget. Your conscious and your wallet will thank you.

 

More on The Dough Roller and MSN Money:

3Comments
Dec 15, 2011 10:29AM
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I"m sorry , but this is just simple math anyone should know.
Dec 15, 2011 12:43PM
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@5437 - Yes simple math that anyone should know, but unfortunately  finances for most people is not about the math, but the emotions. If you always want instant gratification then you will be hard pressed to just look at the math and rationally pay your debts when a new TV can be bought adding only $50 to your monthly statement.

Of course I agree with your sentiment that everyone should treat their finances from an abstract, emotionless, mathematical point but I know people who just cannot seem to do it.

Dec 16, 2011 1:00PM
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@5437 - Totally agree.  Everyone should know, but unfortunately basic financial education is extremely lacking for a LOT of people.  If people can't even iron out this type of stuff, how are we expecting them to save for retirement (IRAs, 401ks, etc.).
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