Editorial Policy

Low Minimum Payments Disguise the Costly Truth

Erica Sandberg

February 22, 2013

QDear Erica,

If I use $2,500 on my credit card, how much would my payment be? The interest rate is 24.5 percent. — Lynn

AHi Lynn,

That's easy! The minimum payment for such a balance would be around $75. You needn't be a math whiz to figure that out. Any good credit card repayment calculator will give you the numbers you seek in seconds. While card issuers all have different formulas for calculating the minimum payment, most use this one: 1 percent of the balance plus interest plus any fees. That way, you're paying at least a bit toward the balance of what you owe every time you make the minimum, in addition to the interest charges. Some issuers will also require you to pay off the whole balance if it falls below a certain amount, say $20.Ask Erica

If a $75 sounds like cause for celebration, though, hold your cheers. Because your interest rate is quite high, only about $24 of that sum would go to the principle. The rest — $51 — would satisfy the financing costs. Keep paying $75 per month, and it will take you approximately five years to become debt free, and will cost you more than $1,600 in interest to reach the finish line. But you asked specifically about the minimum payment. If you continue paying just the minimum (which would decrease as you pay down your debt), you're looking at a whopping 18 years to get out of debt and more than $4,000 in interest charges. Oh, and that's assuming that you never charge another dollar to the account.

So how old are you now, Lynn? If you're, say, 21 and finally legally able to sip a cocktail, you'll be 39 when you hit the zero mark. That's ancient to a woman in her 20s. Or if you're in your early 50s, you'll be eligible for Social Security distributions when that card is paid off. Yikes.

The reason I point out these birthday milestones is to drive home the reality of stretching a balance out to the bitter end. The process is too expensive and lengthy for comfort. So while the bank will be content to accept your tiny payments for more than a decade, you shouldn't be.

The best way to use a credit card is to charge only what you can and will pay in full when the bill comes in. The second best method is to have a short-term installment plan in place. Break up the balance into fixed monthly payments so you're in the clear within one year at the very most. Here are a few examples to motivate you to send as much as possible for a $2,500 debt with the same interest rate:

  • Three-month plan: Send $868 per month; pay $103 in added interest
  • Six-month plan: Send $447 per month; pay $182 in added interest
  • 12-month plan: Send $238 per month; pay $345 in added interest

To know which arrangement you're capable of, develop a budget. Subtract all of your expenses from your monthly net income, and see how much you have left over to send to your credit card company. You can maximize that figure by cutting down on nonessential expenditures or by adding to your income — or both.

Besides paying less in finance fees, another advantage of speedy debt deletion is that when it's gone, you won't have to assign a big portion of your income to what you've already enjoyed. When you've got expensive obligations such as credit card debt, you're living in the past instead of saving for the future. Doing that is just so dreary.

I am concerned about that interest rate of yours. It's bad. Perhaps you had not yet established yourself as a borrower when you got the card, it's a retail card (which tend to have high interest rates) or you fell behind on payments so they hiked it up. Whatever the case, this is your chance to prove your merit. By eradicating the balance in less than a year, you'll be demonstrating to the lender that you are a dedicated and responsible customer. Your credit score will rise, as will the opportunity for you to have a credit card with far better terms.

Got a question for Erica? Send her an email.