Credit cards offer convenience and a way to afford larger purchases that you may not be able to pay for in full with cash. They can also be a way to help you establish and build a positive credit history. However, it's important to understand the true cost of credit cards when interest and fees are factored in. Using credit may be less convenient if it means paying more for purchases over time when interest is factored in. Here's how the true cost of credit can add up.
Paying the Minimum Due Only
It is a common mistake to let yourself get used to paying only the minimum amount that is due on your credit card bill. Paying only the minimum means it takes longer to chip away at your balance. In the meantime, interest continues to accrue steadily on what you owe. If the interest rate is excessively high, your minimum payment may not even be enough to cover the interest charges for the month.
Suppose you were to charge a $2,500 TV set to a credit card with an annual percentage rate (APR) of 18%. Your minimum monthly payment could be as low as $50, but in order to calculate your total long-term costs, you will need to know how your minimum payment is determined.
How Minimum Payments Are Calculated
A minimal payment is typically determined by using a percentage of your entire balance. The percentage amount is usually about 2% but can vary, depending on the card. Keep in mind that the minimum payment goes toward the interest charge and the original amount that you owed. In this case, the original amount was $2,500.
For the $2,500 television, 2% of your original debt would be $50. With an APR of 18%, your payment would cover $38 in interest and $12 toward your $2,500 liability. After the first payment, you would still owe $2,4878. The basic formula is:
- Divide 18% by 360 days of the year, which equals .05%.
- Multiply .05% times 30 calendar days, which is 1.5%.
- Finally, multiply 1.5% by the $2,500 original balance, which equals $37.50 ($38 rounded) in interest.
The True Cost of Credit Cards: What Is It?
If you were to pay only 2% of your total balance due every month, it would take 333 months to pay off your debt. In other words, it would require almost 28 years to pay off a $2,500 liability. The television would probably have stopped working long before you paid it off.
Even if you decided to pay for 28 years, you would also have paid $5,896.48 in interest. Your true cost for the television would end up being $8,396.48.
When you look at the true cost of credit in that context, it becomes easier to see how dangerous the minimum-payment trap can be. You may be saddling yourself with debt for the long-term for things that lack staying power. At the same time, you may double—or, in the case of the TV set, triple—the cost of the purchase by paying interest charges.
Take note that carrying a balance over the long term can impact your credit utilization ratio, which can trim points off your credit score.
Letting Interest Work for You
There's another way to look at interest, and that's in terms of how it can help you grow your money instead. Imagine what you might have earned if you had put the $50 into a savings account for 28 years. Even at today's current low rates, it would have been a substantial amount.
For instance, suppose you started a brokerage account with a 5% rate and deposited $50 every month for 28 years. Let's also account for what you would have paid in taxes with a rate of 25% on the income generated.
Your total savings would have been $36,034. You would have earned $19,184 in interest income. Your total tax cost on the interest (at 25%) would have been $4,796. After taxes, you would have made an extra $14,388. You could have paid for the television in cash and had plenty of money left over.
Don't forget fees. The true cost of using credit increases when you factor in annual fees, balance transfer fees, cash advance fees, and foreign transaction fees.
Avoid Credit Card Pitfalls
Many individuals get tempted by credit advertisements and deals that are too good to be true. However, when you look at the long-term consequences, the low monthly payment offers will usually cost you a lot more money.
It is a good idea to learn about how much a credit card transaction would really cost before going through with the purchase. You can check for yourself by using a credit and debt management calculator. Check out a “minimal payment credit card calculator,” which can tell you:
- Your total cost with minimum payments
- How many payments it will take to pay off the entire balance with minimum payments
- How different rates would affect the total costs
Credit companies usually make huge profits by offering teaser rates and low minimum payments. Those are ways of maintaining their income by keeping consumers in debt for 10, 20, or even 30 years. Instead of adding to their income, you might consider building a savings account by depositing what you would have spent on your minimum monthly credit card payments.
Credit cards can play an important role in our lives. They can provide emergency funds after a car accident or another critical situation and can allow you to recover quickly in a time of need. If you have to use credit, pay your bill in full each month if you can. If you have to rely on making smaller payments, try to pay at least $10 over the minimum payment, and only charge items that you can truly afford. Those measures alone can save you thousands of dollars in interest charges.