January 28, 2016
The Interest Horseman
I used to think that everyone knew about the dangers of minimum credit card payments until I was doing a financial seminar and was asked “who in their right mind ever makes more than the minimum payment on a credit card?” I was stunned and decided to look into this comment and find out if there was any substance to this young lady’s claim.
Let’s start with a definition- the minimum payment is the amount you have to pay your credit card company (or lender) each month — but few of us stop and think about how those monthly amounts are calculated, which makes this one of the four horseman of the financial apocalypse.
In fact, you probably don’t know that minimum payments are strategically calculated to always be about 2% of your total balance. Why two percent? Because that’s the amount that is most likely to maximize profits (i.e. your interest payments) to the bank or lending institution.
Spoiler alert! The bank doesn’t always have your best interests in mind. Who would’ve thought?
So how does it work? Well, you might think that paying 2% of your balance each month would result in paying 24% off in a year (2% x 12 months = 24%). However, since the 2% amount is calculated on a monthly basis and since interest is added to your balance every month, your minimum payments won’t ever pay off 24% of your balance in a single year.
Let’s use an example to show why your balance can stay the same (or perhaps even grow) while you pay all those minimum payments: If you have a credit card with an interest rate of 18%, which is pretty common, and a total balance of say, $10,000, your minimum payment would be $200 and your interest for that month would be about $150. So while you think you’re paying off $200 of your debt, you’re really only paying $50.
Multiply that by twelve months, and you’ll pay about $1800 of interest while only making a dent of $600 in your balanceWhat’s even worse is that if you have an extremely high interest rate — of 24% or more — then paying your minimum payments will actually make you fall deeper in debt each month.
What You Can Do About It
You need to fight this inclination to pay only minimum payments. I’m going to introduce an ugly word here- discipline. It is up to you. In conclusion, I’d like to counter the young ladies quote with one of Mark Twain’s- “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
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