Today we are going to look at a practical example of why you should always make more than the minimum payment on your credit cards. I am going to show you how dangerous it is to rack up credit card debt and how tough it is to climb out from it if you only make minimum payments.
The Setup: Our Balance and APR
Our credit card balance is a modest $5,000. Pretty easy to do. All it takes is a few purchases here and there.
Our interest rate is 20.9% APR. A little higher than average, but definitely have seen higher!
Our terms dictate the minimum payment is to be 2% of the balance.
The Calculations
First, let’s calculate the minimum monthly payment:
Minimum Monthly Payment = 2% of $5,000 = $100
OK, so not bad so far. To the average person, $100 per month for a $5,000 vacation or weekend bender? Worth it! (Hint: It’s not. I don’t care how much fun you had.)
Now, let’s calculate the interest for the first month:
Interest for the Month = (Annual Percentage Rate / 12) * Remaining Balance = (21.9% / 12) * $5,000 = $91.25
Now, subtract the minimum payment from the interest, and apply the remaining amount to the balance:
Payment Applied to Balance = Minimum Monthly Payment – Interest = $100 – $91.25 = $8.75
New Balance = Remaining Balance – Payment Applied to Balance = $5,000 – $8.75 = $4,991.25
Ooof! We only made a small dent in our balance.
We need to repeat this calculation month over month. And when we do, we find that it will take a whopping 9 years and 11 months to pay off the balance! And the total interest we would pay to the credit card company is $6,853.15 – which is more than our balance! In fact, we would have paid $11,853.15 for that $5,000 weekend bender.
Still worth it?
Changing the Math: Using a Higher Than Minimum Payment
Let’s increase our monthly payment by $35 a month, so we budget to pay $135 a month rather than just the minimum payment.
Crunching the numbers again, we save almost $3800 dollars in interest alone and can pay off the card in 5 years. The total interest we would pay is $3,098.49 as compared to $6,853.15. That’s better.
But what if we go one step further? Let’s say you can afford double payments. $200 instead of the $100 minimum?
It will take 2 years and 10 months to pay off the card, and you will have paid $1,621.60 in interest for the $5,000 charge, saving an incredible $5,231.55.
Conclusion – More Is Always Better
You may not always be able to make double payments, or even higher than minimum payments every month – but adding more than your minimum payment will shorten the amount of time it will take to pay off the card. And it could save you thousands of dollars in interest charges.