Somewhere on your credit card statement there is a note saying if you only make the minimum monthly payment each month, it will take you a certain number of years and months to pay off the balance – BUT ONLY IF YOU NEVER ADD ANY MORE CHARGES TO THAT CARD AGAIN!
Your credit card agreement will specify the minimum payment that is due every month. This amount is generally a certain percentage of the balance owed. This percentage can often be based on factors such as your credit score and the limit on your card.
Basing it on a percentage instead of a fixed amount (like a consumer loan, for example) works in the credit-card company’s favour because the minimum monthly payment reduces as your balance reduces. It will take decades to get out of debt and cost you hundreds, if not thousands, of dollars in interest.
At one time, minimum payments were 5% of your balance, but they have gradually reduced to an average of 2%. My personal Capital One MasterCard requires only 1.45%.
According to a recent TransUnion survey of Canadian credit-card holders, 44% of respondents pay their credit card balance in full each month, and 9% just pay the minimum. Interestingly, it varies by province, with consumers from Ontario (27%) and British Columbia (20%) most likely to pay the minimum.
Even more disturbing, since many credit cards require only a payment of 2% of the monthly balance, it will take over 30 years to pay off the balance and Jacob will end up paying more than $19,000 in total payments.
Minimum payment = minimum progress
Many people think if they make at least the minimum payment, they do not have a debt problem. It’s true that their credit score may not be at risk, but it can be a gateway to a bigger credit problem. Making the minimum payment is tempting when money is tight and you may like the idea of smaller payment, but paying only the minimum is like treading water.
Getting stuck in a cycle of minimum payments can seriously affect your future plans, preventing you from meeting other goals, or building a reserve of funds. Some unpredictable and costly event is bound to come up and, with no emergency fund, there is no money available to pay for it. Then your only option is to rely on more credit to finance the emergency. This erases all the progress you have made, and so perpetuates the cycle.
The best strategies are:
- Pay as much as possible in the shortest amount of time.
- Pay off high interest credit cards before beginning to invest.
- If you must carry a balance, seek out a credit card with a low interest rate.
- If you are only able to pay the minimum right now, continue to pay the same fixed amount as your balance decreases.
- If you have multiple cards, use the snowball or avalanche method to pay them down.
Use a credit card debt calculator (like this one) to see how long it will take you to pay your debt – and the total amount of interest you will pay.
The bottom line
Paying just the minimum monthly payment on your credit card might keep your credit score in decent shape, but it’s not going to do much to pay down the balance. Paying hundreds, or thousands, of dollars a year in interest is a financial disaster that should be remedied as quickly as possible.
Paying off high interest debt quickly is the best investment you can make.
Marie Engen is the “Boomer” half of Boomer & Echo. In addition to being co-author of the website, Marie is a fee-only financial planner based in Kelowna, B.C. This article originally ran at the Boomer & Echo site on July 18th and is republished here with permission.