The credit card minimum payment trap

Whether we like it or not, money, particularly a lack of it, greatly affects our sense of serenity and ability to enjoy life. This is the first of a series of posts that will analyze several strategies that you can use to get out of debt. In this article I’d like to focus on the single biggest mistake consumers make.

Struggling with debt

US households are struggling with debt. The total consumer debt reached a staggering $2.570 trillion in May 2008. This huge number is based purely on credit cards and other loans which aren’t backed up by real estate properties. As such, this figure doesn’t include the trillions of dollars of debt which is due to mortgage loans.

The average American already owns 4 credit cards, and to make matters worse — despite a sharp decline due to the subprime mortgage crisis — 1.132 billion credit card offers were mailed out in the first quarter of 2008 alone. These generated a response rate of 0.4%, therein creating millions of new credit card requests.

An excellent documentary on the subject of debt and predatory lending is Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders (also available as an Amazon Unbox download, and in book form). It’s been a wake up call for many and is highly recommended.

There are many reasons why people get into debt and not all of them can be blamed solely on frivolous or unwise spending habits. The younger adult bracket is, for example, characterized by significant debt which was incurred due to student loans. With an exception made for higher income households, for almost 1 in 3 Americans, medical bills were a contributing factor to their current debt status. To top this off, salary increases have failed to counterbalance the negative effect of inflation and the basic cost of living. It’s worth pointing out that this is not a problem which is limited to Americans. Citizens from the UK, Canada, Australia and other countries in the Western world are facing similar difficulties.

Whatever the reason for their debt, chances are that many readers of this blog are facing these kinds of struggles, and it’s an undeniably tough situation to be in. When most of your paycheck goes towards paying rent (or mortgage payments) and consumer debt, your perception of stability and security starts to falter, and you truly feel vulnerable.

About half of all US consumers carry a balance over from month to month, while around 11% of them cover only the minimum monthly payment. Paying back debt that’s been incurred is painful when you’re already living paycheck to paycheck and having trouble meeting the cost of essential needs like housing, food, transportation and health care; but paying revolving credit card companies the minimum amount that they ask you each month, is a sure way of remaining in debt for decades — while earning them huge sums of money in interest. Let’s see how this works and why it’s a dangerous trap for consumers to fall into.

It’s a trap, and you’re the mouse

Many people wrongly assume that covering the minimum repayment on time each month is an affordable way to pay off their credit card debt. Simply stated, this couldn’t be further from the truth.

In general, the minimum payment due is a certain percentage of the current balance or a minimum amount (e.g. $10), whichever is greater. The percentage is credit card specific, but 3% or 5% are common numbers. Credit card companies like to have this percentage low, because it will take you longer to pay it off and in the process you’ll end up accumulating more interest for them, as long as you primarily make only the minimum payments due.

The monthly interest that the company charges you on the other hand, is obtained by dividing the APR (Annual Percentage Rate) by 12 to obtain the monthly interest rate, and then multiplying it by the balance you’re carrying.

Imagine that you have a 19.5% APR credit card with a balance of $4000 and 3% minimum payments (or $10, whichever is greater). If you were to only pay the monthly minimum, how long do you think it’ll take to pay off the amount owing in full and bring the balance back down to zero? It would take you 19 years. Or in other words, your last payment would be in 2027. Not only that, by you’d have paid back the initial $4000 plus more than $4500 in interest as well. And this doesn’t account for possible annual or late payment fees. As you can see, only paying your minimum payments is a trap that will keep you in debt for a ridiculously long amount of time.

Putting a fixed amount (that is greater than the minimum) each month towards that debt will extinguish it much sooner. The table below shows you the amount of time and interest spent, for several possible monthly amounts.

Keeping a relatively high balance/limit ratio for a long time will also negatively affect your credit. No matter what it takes, and we’ll discuss ways to handle this, it’s crucial to pay more than the minimum payment required.

Paying the minimum on some of your credit cards is OK if you have a plan, a mathematically sound system to get you out of the hole you’ve dug yourself into. Two different methods that are commonly used to tackle debt are debt snowballing and debt avalanching. In my next article on the subject, I’ll cover and compare the two.

Feel free to anonymously share your situation and plans, if you’re struggling with debt.