If you only pay the minimum required, it takes a longer period of time to pay off your debt, and because of interest, extending your payments over a longer period of time means that you actually have to pay more than you otherwise would.
In fact, you may even end up having to pay a sum of several times the original amount due!
Basics to understand about minimum repayments
- The interest rate. You need to pay the bank interest for lending you money. If you borrow $1,000 at 20% APR over a year, you will have to pay an interest of $200 (20% of $1,000). The higher the interest rate, the more the debt costs you, and the longer it takes you to pay everything off. You not only have to pay interest, you pay interest on interest, interest on interest on interest, interest on interest on interest on interest...and it goes on! This is compound interest working against you.
- The duration of borrowing. The longer you take to pay off your debt, the more interest you are charged as 20% APR means you are charged 20% of your outstanding debt every year, in addition to compound interest. Most minimum payments will barely cover the interest and finance charges that are due on the balance. The sooner you repay, the less your overall debt costs.
- The minimum repayment. It is up to you how much you want to repay each month, as long as it is equal or above the prescribed minimum repayment. In the U.S., it is usually 2% of the outstanding debt. If you don't even pay the minimum required, you will have to pay a fine.
The dangers of minimum repayments
For example, if you owed $5,000, had a 20% APR, and you paid just the minimum every month ($100, which is 2% of $5,000), it would take you over 9 years to pay off the debt and during this time you will be paying interest! And all this is assuming you don't use your credit card for any additional transactions and that you are not charged any fees while you are paying the balance down.
So if you continue to spend on the credit card, the minimum amount will increase each month - and that's just to service the interest. And all the while you are reducing your debt by a tiny fraction.
Minimum payment is absurd when you consider how long it would take to pay off a modest debt.
Most of your repayment usually just goes to paying that month's interest, with very little actually going to reduce the amount you owe.
As consumers, it is in our interest to repay debt as fast as possible. However, the lenders' interest is the opposite: they want to keep you repaying your debt for as long as possible and earning them substantial interest. The way they do that is with minimum repayments.
Credit CARD Act of 2009
Since February 2010, U.S. lenders have to tell customers how long it will take and the interest that would be charged if only minimum repayments were made. It is hoped that this information will persuade cardholders to increase their monthly payments, and thus get out of the debt spiral sooner.
What you should do instead
If you overpay your minimum payment, you can easily avoid this pitfall. Add between $10-$50 to each minimum payment every month, and you will see your outstanding debt becomes smaller. It may take months, or even years for you to repay that debt, but with each overpayment, you are shortening the length of borrowing and closer to being debt-free.
Things get even more complicated with you need to pay off debt for multiple credit cards. Here's how you can manage the credit card debt due on multiple cards:
First, find out the interest rate for each card, and read through the terms and conditions of each card. Note which card charges the highest interest rate, and then arrange your payments so that this card receives the largest amount above its minimum repayment. Over time, this will reduce your overall debt more efficiently. If your debt becomes unmanageable, you should try to negotiate a lower interest rate with your lender.
Compare Credit Cards and find one that best suits your needs.