Only Paying the Minimum, Sucker?
Posted by John Draper | Filed under Credit Wise, Debt Traps, Take Control
I work with a lot of people who have credit cards on which they are making only the minimum payment each month. Sure, they’re staying on the right side of their credit scores, but what they’re doing is stupid.
Let’s say you’re using a MBNA Mastercard that charges 17.99%* interest on purchases for which the minimum payment is the lesser of your interest +$10 + fees, or 2.25%, whichever is less. Now, let’s say you’re carrying a balance of $3,600 and are making the minimum payment, which would be about $64 (the interest + $10). Since you’re only paying $10 a month off the amount you owe, it’s going to take a loooong, loooong time to get this card paid off. How long exactly? Well, 106 months, or 8.8 years! And do you have any idea how much interest you’ll end up paying on that $3,600 balance? $3,384. Yup. Almost double what you originally charged. Those shoes you bought at 30% off don’t look like such a good deal right now, do they?
MBNA also has a card on which it charges 19.99%. Let’s see how those two extra interest points affect how much you end up paying in interest. First off, you’re minimum payment would go up to about $70 a month. Your interest costs would jump to $3,997 – more than you originally charged. Can you see why it’s so important to get the lowest possible interest rate if you’re carrying a balance?
I scratch my head. Really I do. Why would anyone use a credit card from MBNA that charges 19.99% or even 17.99% when you can get a card from Citizen’s Bank that charges only 11.25%. Want to see how that same balance would play out on a Citizen’s credit card? First off Citizen’s Bank’s minimum payment is “$50 or 3%, whichever is greater.” Hey, it looks like they want you to get the balance paid off! That same balance would take 78 months or 6.5 years – still way too long people – and would cost $1220 in interest, which is a far cry from the $3,997 MBNA wants you to hork up.
Okay, so interest rate is a big deal. But only paying the minimum sets you behind the eight-ball in terms of how long you’ll be in debt regardless of the interest rate. So how do you get yourself out of the hole in a reasonable amount of time?
Well, why don’t we start with what a “reasonable amount of time” actually is. In my book – my best girlfriend, Cookie, used to say, “according to the Book of Gail” and I still laugh when I hear her voice in my head – you should spend any more than 3 years – or 36 months – getting your debt paid off.
Debt fatigue is what happens to you when you’ve been in a hole so long you can’t see up anymore. You’ve lost hope. You’ve started spending again after being overwhelmed by the amount of debt you have and the seemingly futility of your debt repayment process. You’ve given up and gone shopping.
To avoid debt fatigue, you have to be able to see the light at the end of the tunnel, and that’s absotively, posolutely no longer than 36 months.
So you want to be paid off in 36 months, do you? Well, the rest is easy. Take your total owed – let’s say it’s $2,500 – and divide it by 36. The answer: $69.44. That’s how much you have to pay off the principal every month to get out of debt in 36 months. Before you go jumping up and down and screaming, “I can do that, I can do that!” remember you also have to pay the interest cost. On that $2,500 at 11.25%, your interest cost will be (2,500 x 11.25 / 100 / 12) $23.44. So if you make a payment of ($69.44 + 23.44) $92.88 a month, you’ll be back in the black in just under 3 years. And it will have cost you $395 in interest.
You can afford to pay more than that, you say. Great! Let’s say you can afford to pay $100 a month. You’ll be out of the hole about five months sooner. Up your monthly payment to $125 and you’ll be debt free in less than 2 years. Get another job, earning an extra $100 net a month, and up your payment to $225, and you’ll be debt free in a year.
How long you’re prepared to live in misery is up to you. You can bite the bullet and do what it takes to reclaim your life, or you can keep whining about how hard it is to get to even. But while you’re whining, you’re paying a ton of interest too, money that could be better used doing something nice for someone you love: you.
*All rates quoted are from the Financial Consumer Agency of Canada on April 26, 2007.
May 8, 2008 at 9:48 pm
Simple math works well on being discouraging on the monthly payments deal on furniture, electronics, etc…
That’s one thing that always freaks me out about my sister’s view of money… ” You can easily afford the minimum payments on that! You should buy it!” In my head I am doing up the math as fast as I can about what it will REALLY cost out of my family income and I shudder…. (X) amount over (Y) number of payments …. !!!! Aaack! That’s no bargain!
May 8, 2008 at 9:55 pm
Another piece of Gail’s advice that I have listened to and taken action on. I increased my monthly payments to as much as I can afford while still saving a little something. Instead of taking 28 months to pay off my credit card debt, I will now take 20 months. Yes! I’ll be completely debt free by Christmas 2009! (Or a little earlier if my search for a new job is successful.)
Thanks Gail for showing me the light! LOL!