Last Updated on 16 March 2021 by Dan
The Financial Wilderness is a fan of credit cards under only very specific circumstances – namely that they’re paid off in full each month or part of a well planned expense you know you can pay back. When they’re not, they can create an ever growing debt spiral of o’pain (official financial term) – this entry seeks to explain why.
This post is about prevention. If you’re already there and need a cure don’t panic: the next post will be about strategies we can use to turn this around.
Why is Credit Card Debt a Problem?
The big thing that’s changed recently and can make this tricky to manage is having visibility over spending. I love contactless because it makes things so quick and easy, but also just a little too quick and easy – you can rack up that total fast without feeling like you’re spending anything……
So when that statement comes in many people see the option for a minimum payment which is a relatively small amount each month. It’s tempting because it seems a much smaller commitment, or it might not be your available funds – but in either case if you’re just paying the minimum this blog advises you to do one thing……
Why you should avoid the Minimum Payment on your credit card
Let’s head back to what we’re trying to achieve financially with the Golden Rule:
How do Necessities (We ensure) + Luxuries (We challenge) + Wastage (We eliminate) balance against Core Income (Your job) + Investment income (We maximise) + Other Incomes (We seek opportunity)
When you pay the minimum payment the entire rest of the balance is subject to interest – I.E because you are essentially being loaned money, the card provider will charge you for that. This is essentially wastage over time.
Now in a later article this blog will talk about the magic of compound interest and how it will do wonders for your investments – but with credit card debt it’s more like black magic, slowly sapping at your soul.
Let’s demonstrate: Assuming £1,000 spent a month on a card charging 2.5% interest a month and requiring a minimum of 5% of the balance to be paid off we end up with the following.
|Month||Outstanding debt (pay off in full)||Outstanding debt (pay minimum only)||Required minimum payment|
Yikes! Not only is that minimum payment accelerating worryingly fast, your overall debt is getting pretty big, which can lead to additional problems with obtaining further finance.
How am I losing out by paying the minimum on my credit card?
Now let’s show the wastage here in the form of those interest payments.
Let’s say we received a big cash windfall and pay the card off in full after month 6 and compare results.
If we’d simply paid off the card immediately each month we’ve simply paid £6,000.
However, having paid the minimum each month before paying off the card in month 6, instead we’ve paid £5619.76+£237.91+£192.26+£146.06+£98.69+£50 = £6,345 (£6,000 pure spend and £345 of interest cost)
You know what? I reckon that’s £345 lost we could be doing a heck of a lot more with. Let’s get there. If you’re not paying off in full, check out the next article on practical strategy to get those credit cards under control.