Minimum payments on credit card debt are usually calculated as a percentage of the balance plus the interest accrued during the billing cycle. But paying only the minimum is not such a good idea because it will accrue unnecessary interest.
For example, let's say we have a $10,000 balance on a credit card. If we do what the credit card company wants us to do and only hand over the minimum payment of $200 each month, then that credit card will take 8.3 years to pay off completely, which is a very long time. And over that time, we would have to pay a total of $9,971 in interest, which is almost the same amount as our original principle amount.
Instead of doing that, let's say we pay $500 a month. This time, it will only take us two years to pay off that debt, and our total interest paid would be just $2,119. The difference between the outcomes of the two scenarios is huge. But the difference in our monthly payments is only $300 a month. Therefore, increasing our payments would allow us to pay off credit cards sooner, and also save us lots of money in interest.
If we have multiple credit cards, it's best to pay off the one with the highest interest rate first, regardless of which ones have the highest or lowest balance. This is because the cost of borrowing money is the interest rate, which applies universally to every dollar we owe, no matter where the debt is held.
Credit card companies will sometimes offer promotional rates, with a reduced annual interest rate, sometimes as low as one or two percent. These low rates usually last for six to 12 months from the time someone applies for them, and can dramatically lower the cost of borrowing for a short period of time. But it's important to remember that the promotional rate only applies to the existing balance on the credit card, and any additional purchases charged to the card will still be charged at the regular interest rate, or sometimes even higher.
A good strategy here is to use the low interest rate period to aggressively pay down the outstanding balance as much as possible before the promotion ends and charge your regular credit card expenses to another card. Another way to use these offers is to do a balance transfer. In other words, transfer the existing balance from other credit cards and debts with higher interest rates to these cards with a lower rate. Before transferring a balance however, ask if there are any fees.
In conclusion, remember to always make sure to read the fine print before signing up for any credit product, check the statements each time and report any irregularities immediately.
Liquid is the primary contributor for Freedom 35 Blog, where he writes about investment strategies as well as commentaries about business, finance, and economics.