Why Minimum Monthly Payments Are Financial Suicide
“If it sounds too good to be true, it probably is.” This old adage especially applies to the credit card industry. Frequently we receive offers for “0% interest” that will go up to 9% after six months and “free balance transfers” that aren’t really free. Lenders tempt us with higher spending limits, ATM cash advances and greater rewards for greater expenditures. It can be easy to lose your financial sense when dealing with credit card companies who promise the world – for a price.
While credit has undoubtedly opened up purchasing power for millions of Americans – providing increased opportunity, moving more of our poor to the middle class and the middle class to the upper echelons, these changes in the way we live aren’t always for the better. We’ve lost our sense of honesty, the ability to look ourselves in the mirror and say “My name is Bob: I am a gas station attendant making $15,000 a year. I cannot afford to live in a $300,000 house or drive a $30,000 car.” We forget what “living within our means” amounts to anymore and lose the value of saving up our money to buy what we need.
The most dangerous tool credit card companies offer us is the “minimum monthly payment” option. As a borrower, you’re told you can buy as much as you like as long as you pay just 4% of your overall balance each month. Not surprisingly, many people choose to keep a revolving balance and just meet their monthly requirements, without giving a second thought to how much the interest charges are escalating and how long it will then take to pay off this full balance.
Video: Don’t Skate By On Minimum Monthly Payments
The Real Cost of Minimum Monthly Payments
So let’s take a look at how this minimum monthly payment option works itself out over time. According to MSN Money Magazine, the average household credit card balance is around $8,000. The average interest rate is at 12.65%, says the Index Credit Cards list. Your minimum monthly payment would be around $32. To pay off this debt, it would take you 109 payments or more than 9 years! The worst of it is that you will pay $2,720 in interest charges alone! Don’t forget that while you’re carrying this balance, a transaction fee of fifty cents to $5 will be added to your balance each month. Creditors determine your finance charge by looking at last month’s balance, the average daily balance and the adjusted balance.
This idea quickly spilled over into the mortgage world, where “Pick a Payment” became a vehicle to foreclosure and financial ruin for more than a million homeowners. Under this adjustable rate mortgage agreement, homeowners were given the option between several different payments – and, not surprisingly, most people chose the least expensive option. Borrowers are allowed to continue doing so for up to five years, at which point they must start paying a higher rate to hack away at their principal balance. According to First American Loan Performance, the average monthly mortgage bill increased 63% from $1,672 to $2,735. Today we see the devastating effects of this minimum monthly payment option in the number of foreclosures.
Rule of Thumb: How Much to Pay
Ideally, financial experts say you should be paying off your balance in full each month. Don’t let those credit card companies make a single dime off you! Be a responsible borrower and spend within your means: these are the conventional words of wisdom.
However, for many of us who have already extended well beyond our means, this is simply not feasible. How can someone possibly come up with an extra $8,000 just lying around after months of reckless borrowing? You may have to make some sacrifices to get out of this debt fast. It could take working another job, working over-time, selling some of your personal belongings on eBay or eating out less often.
To put things in perspective, you should use a debt reduction calculator to see what it will take to pay off your current balance. For example, if you wanted to get rid of that gnarly $8,000 balance this year, you’d have to make minimum monthly payments of at least $714/month, rather than the suggested $32/month. By paying this aggressive higher amount, you will save $559 in interest fees! If you’re in no big rush, you can pay a lower $379/month to dig out of debt in two years, although you’ll be whacked with $1,096 in interest charges during that time.
A good way to aggressively pay down your debt is to make a list of all your fixed expenses like rent/mortgage, utility bills, minimum monthly payments, food and transportation costs. Subtract the total from your monthly income to see what you can afford to pay on your credit cards. If you have one ugly balance, drop all your remaining cash on it. If you have several problems, then start with the highest rate interest card and pay that one off first, while paying the minimum monthly balance on the rest. Once that highest interest card is gone, aggressively focus on the next card. Once you’re finished paying off your debt, use your card wisely and never ever fall into the minimum monthly payment trap again!
Video: “Balance Chasing” - Credit Interest Rates Rise Dramatically
What Is a Reasonable Interest Rate?
A reasonable credit card interest rate these days ranges between 5-11%. Again, if it sounds too good to be true, do not trust it! In 2006, some Capital One customers reported receiving a 2.99% introductory interest rate offer only to find their first statement reporting a 10.42% rate slapped onto their transferred balances. After calling customer service relentlessly and being continuously assured it “would be taken care of,” these consumers had little recourse other than to file official complaints and stomach the high bill.
There are some cards that do offer a 0% interest on balance transfers for the first six months, but this can be dangerous road to take because there’s no telling what you’ll be faced with after the six months and you will undoubtedly be charged a “transfer fee” which could be 3-5% of your total balance.
On the flipside, some consumers report being charged rip-off rates of as high as 38%! Creditors like American Express have been accused of raising interest rates suddenly based on where their customers are shopping! They can also raise interest rates just because you’re not paying off your balances. While this may seem illegal at first, you’ll note on your agreement that creditors give themselves full leeway to raise your interest rate as they see fit; so you’re wise to keep a low balance so you can quickly terminate your relationship with them if they decide to raise your rates suddenly for no good reason.
Another Mistake to Avoid
In addition to the minimum monthly payment and interest rate traps, many consumers – particularly parents – fall prey to credit card sharing. College students who can’t gain access to credit often wish to piggyback off their parent’s credit by sharing an account, but the negatives far outweigh the benefits. Perhaps someone in the household is looking to rehabilitate his or her credit by taking out a card in a family member’s name. In other cases, a married couple with a joint bank account will simply decide they want a joint credit card as well. These are all truly foolish maneuvers, as both parties will be 100% responsible for the debt accumulation. Both credit scores will drop when payments are missed, both parties will suffer harassing collection calls and both people will suffer a dire financial future. Remember, there is never a good reason to share a credit card!
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