In previous articles, we have explained how compound interest can work against you in paying down debt. For each dollar of balance, you incur new interest charges that make paying off debt just that much harder. To make the task of paying down debt worse, credit card companies suggest a “minimum payment” that will decline over time as your balance declines. Although this sounds great, it actually works against you. Read this article for a detailed explanation of why this “minimum payment” actually causes you to pay more in interest.
Let’s take a more detailed look at how credit card minimum payments work. For this example, assume that you have a $10,000 balance on a credit card with 18% interest. If you pay only the minimums, your balance will decline over time, but so will your payment and as a result the amount of principal that you pay off each month will decline as well. Let’s compare this scenario to one in which you start at your current monthly minimum payment of $400 and hold it constant over time. The following graph shows these payments over time:
Note a couple of things in this graph: First, the minimum payments decline significantly over time while the constant payments stay constant at $400. Second, the minimum payments are extended for 12.5 years while the constant payments end after 2.5 years. This is when your debt would be paid off if you hold your payments constant-about 10 years earlier-all without paying any more than the starting minimum payment.
How does this impact how long it takes you to pay off your debt? Because you pay more in each month under the constant payment scenario, this extra payment amount gets applied to your principal reducing it in the current month and resulting in lower interest payments in every subsequent month. Because you’re future interest payments are lower, you apply more and more to principal in every following month. Over time, this begins to rapidly reduce your balance…it’s compounding interest working in reverse. Here’s what would happen to your balances in each of the scenarios:
So by holding your payment constant at the initial minimum payment amount instead of letting it decline over time, you can pay your debt off 10 years earlier. During this time, you aren’t continuing to pay interest, so it stands to reason that you’ll save in interest. How much? Nearly $3,200! All without paying any more against your account than your minimum payment when you started. No wonder credit card companies encourage you to only make minimum payments-each month they lengthen the time it takes you to pay off debt puts more money in their corporate coffers.
So what’s the smart move? Set a fixed amount that you can pay off each month against your debt even though your minimum payments decline. This can become difficult if you have more than one account, especially if you try to optimize your payments by allocating as much as you can toward your highest-interest account. This is where DebtGoal.com can help. We help you set a constant monthly amount and stick to it over time. As you pay down balances on lower-interest accounts, we calculate a payment schedule that automatically applies as much as possible to your highest-rate account, getting you out of debt as quickly as possible. This technique can save an average family over $60,000 in interest over the lifetime of their debt.
Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs. DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.
Tags: Credit cards, Debt Stacking, interest payments, minimum payments, snowballing
