When you buy stuff with a credit card, you are basically borrowing the money from a lender with a promise to pay it all back. The longer you take to pay it back, the more it’s going to cost you.
If you try to squeak by and pay only the minimum amount due each month, it will take years to pay off and cost much more than the original debt.
Adding just $20 a month to the minimum payment can drastically cut the time it takes to pay off the debt. You also can knock hundreds off fees and interest charges.
How it works:
Let’s pretend you just hit a great sale to get a new 60-inch flat-screen TV for $1,000. You put it on a credit card that has an 18 percent APR and a 2 percent monthly minimum payment.
I used the Federal Reserve calculator to show you three ways to pay it off using the $20 monthly minimum payment, a $40 monthly payment and a $92 monthly payment:
Annual Percentage Rate (APR)
Years to Pay Off
Total Interest Charges
If you only pay the monthly minimum payment of $20, your $1,000 TV will actually cost you $1,863 ($1,000 + $863)! You will be paying for that TV for eight years, even if it quits working or becomes out of date.
If you pay $40 a month, you can save $600 and five years of payments! Isn’t that worth skipping a few trips to the coffee shop each month or spending a Friday night at home?
If you pay $92 a month, you can pay it off in one year. Lower interest rate charges bring the total cost of your new TV to $1,101.
“This is a much easier
way to save money.”
Looking to save money with your credit card purchases? Open up a low-APR credit card.
How they calculate payments:
When you send in the minimum monthly payment on a credit card bill, it does not all go toward paying down the debt for your new TV. Every credit card issuer has slightly different calculations, but this is the generic formula:
1% of balance + Interest and fees (typically 1% of balance) = 2% minimum monthly payment
This means only half of your minimum monthly payment goes toward the balance. The other half goes toward interest and fees.
However, if you pay more than the minimum, the credit card issuer must by federal law apply the additional payment to your balances.
Annual Percentage Rate (APR)
What Goes To Interest/Fees
What Goes To Your Balance
After 1 Month
What’s the catch?
When you pay more than the minimum payment, it has to go toward knocking down your balance, but it may or may not go toward paying down the specific balance on your flat-screen TV.
Under the federal 2009 Credit Card Accountability, Responsibility and Disclosure (CARD) Act, any amount you pay over the minimum must be applied to balances with the highest interest rate.
This comes into play if you have different APRs for new debt, cash advances and balance transfers.
If you took a cash advance on your credit card, it will be paid off first – before the debt on your new TV. It’s a bit confusing, but it really doesn’t matter as your total bill adds them all together.
The CARD Act is simply designed to help you knock out debt with the highest interest rates faster.
Still not convinced?
Here’s one more reason to always pay a little more on your credit card — cardholders who only pay the minimum can get placed in a higher risk category, which could trigger an interest rate hike.
Higher interest rates mean higher monthly payments, which means less money going toward paying down your debt.
Ready to open a credit card of your own? Check out our hand-picked list of 2014’s best.
Photo source: soloincolo.
Editorial Note: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, airline or hotel chain, and have not been reviewed, approved or otherwise endorsed by any of these entities.