Reasons To Pay More Than The Minimum Payment

Reasons To Pay More Than The Minimum Payment.  Arguably, the intent of a credit card is to have you in debt so that you pay huge amounts of interest,

which is by far the largest source of income for credit card companies. The most effective way they do this is by allowing you to pay only the minimum amount, which works out so that you pay almost only interest.

How Minimums Cost You  

In the past, minimums were much more benign. They used to be set at relatively high percentages, anywhere from 5% to 10%. While this meant that you paid more, your debt would get paid back faster and your loss to interest would be less.

This changed when credit card lenders realized that they could set the minimum payments lower, and collect a smaller amount of money each month for a much longer period of time. This had the effect of meaning more money would go only to interest while the companies could make people think that debts on their cards was "affordable."

The Mechanics of the Minimum Payment    

A minimum payment is the smallest amount that you must pay each month to avoid defaulting on the debt. Not paying the minimum has nasty consequences, but this doesn't mean that it's alright to only ever pay that much.

Consider This Example   

Take an example where you owe $1000, and your interest rate is 12% per year (1% per month). Further, your minimum payment is set at 5% per month. In this example, as in real life, the first money you pay goes to interest first and debt second. So, $10 out of the $50 you pay disappears as interest. However, $40 would still go towards paying off the debt, meaning that your debt the next month would be $960.

What if we change the scenario to something a bit more like what we have today? Lets’ make the minimum payment 2%. While you only end up paying $20, $10 still goes to interest. Thus, there is only a $10 reduction in debt, meaning you owe $990. 

The difference in actual principal payment is understood by few, which costs most people horribly. 

In our more realistic example, 50% of the payment was going to interest – meaning that paying the minimum gets you an effective 50% interest rate, even though your APR was only 12.7%. This situation only becomes worse: there are cards out there where only making the minimum payments will actually cause you to owe more each month, not less!

How to Avoid This

The overall tactic should be fairly obvious; you should always pay as much as possible every month. However, if you don't think you can discipline yourself to do this on your own, look for a card with a high minimum payment. Though you pay more now, the savings will be huge in the long run.   

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