Credit Cards – Looking At the Cost of Paying the Minimum Due

01/23/08 posted by Tricia at Blogging Away Debt

Way back when, I thought we were doing well financially. We were making money and we were able to pay all of our bills. Every few weeks I would sit down and cut some checks for the amount showing as due.

I didn’t think much of it at the time, but I always paid the minimum amount due showing on my credit card bill. Why do I need to send more? Just cut a check for the amount that they want and it’s all good.

I was wrong… very wrong.

Now that I’ve learned a few things about our finances, I see the error of my ways and I am going to show you what I learned (thanks to a handy calculator at Bankrate.com). Take for example the graph below:

Years Till Pay Off

Let’s say you have $5,000 balance on your credit card and you do not use it anymore. You decide to only pay the minimum amount due on your bill in order to pay it off. In this example, the minimum payment is 2.5% of the amount owed. Each time you pay the minimum payment, your balance would go down a little bit and so would your next minimum payment. It would take you over 20 years to pay off your card using this method.

On the other hand, let’s say that you decide to take that first minimum payment (which is $125 in this example) and set that as the amount you are going to pay to your credit card every month. You are used to the payment, so why not just keep paying that amount?

It’s a pretty good idea because your debt will be paid off in less than 5 years by doing it this way.

Pretty amazing, isn’t it? It makes me feel a little silly to admit that I used to only pay the minimum payment all the time (and we were also still charging on our cards, but that’s a different story!).

That’s not all, though. Just look at the money you can save by paying more than the minimum:

TFCP

You can save over $2,700 in finance charges by paying $125 a month versus just the minimum payment! I can think of a gazillion better uses for $2,700 than giving it away to my credit card company. What about you?
It’s easy to get in the minimum payment trap. I was there and back then I didn’t think twice about only paying what our credit cards said we had to pay. But when you run the numbers, paying a fixed amount a month can make a huge difference.

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Tricia is the blogger behind Blogging Away Debt. In her blog, she documents her family’s journey to pay off over $37,000 in credit card debt. Part of her debt reduction plan included a loan from Prosper.com. It originated in June of 2006 and was paid in full in October of 2007.

Posted in Personal Finance Education

7 Responses

John Peterson | January 23rd, 2008 at 8:57 am

Thank you for the great info. The link to the credit card interest calculator is great.

There is no doubt that being in debt on credit cards is not the ideal situation. However, if you have money in the bank and adequate insurance to cushion unexpected occurrences such as job loss or disability, and your credit card debt is of low interest then paying the minimum may not be all that bad. Let’s say your credit card interest is 5% fixed. You can take the extra money you would have used to pay back your credit card and instead put that into Prosper.com. The loan on Prosper.com could get you 10% or higher. That extra $100 you would have put into a credit card loan at 5% interest is instead gaining 10% interest on Prosper.com.

Now, that interest isn’t tax free. The IRS wants their cut. In the worst case scenario your interest that you made would be taxed at 35%. That would reduce your actual interest earnings on Prosper.com to around 6.50%. So you would still be making 1.5% interest on the difference.

Here are some other scenarios:

* Tax rate: 28%, After tax earnings: 7.20% (2.2% diff)
* Tax rate: 25%, After tax earnings: 7.50% (2.5% diff)
* Tax rate: 15%, After tax earnings: 8.50% (3.5% diff… woohoo)

This would of course require that you do your homework on Prosper. That you have adequate savings to make sure you *always* pay your monthly credit card bills. That you already are funding your retirement with adequate levels of income. That your interest rate on your cards does not change. That you do not charge to your cards with the fixed rates ever, and that you don’t mind the credit card monkey being on your back. Anyway, that’s my two cents

JOhn

P2P-Loans.com | January 23rd, 2008 at 10:16 pm

Great post and thanks for sharing. Credit cards can be a useful tool for consumers, but they can also be a dangerous trap (as you’ve illustrated). The beauty of a Prosper loan is that it is a fixed 3-year term and it is gone after 3 years. With discipline so hard to come by these days, sometimes borrowers have to force their own hand through loans like what Prosper offers.

Will | January 23rd, 2008 at 11:23 pm

Tricia,

Great blog the numbers certianly are “eye opening” to say the least. Congrats on getting out of debt.

Frugal Dad | January 24th, 2008 at 8:29 am

I have a feeling that more and more will only be able to pay minimums on their credit cards because they took on a mortgage they couldn’t afford before the became debt free (and the banks approved the loan). House-poor households may have credit card longer than they have a mortgage!

Caitlin | January 25th, 2008 at 9:45 am

Wow! These graphs sure paint a very vivid picture of what happens when you only pay the minimum!