Here’s how only making the minimum payment on a £2,500 credit card debt could take 50 years to pay off and cost you over £10,000...
It seems there’s good news on the horizon for credit card borrowers. Last week, business secretary Lord Mandleson met once again with the big boys of the credit card industry and agreed a number of measures to ensure customers are treated more fairly.
The steps brought in include more breathing space for those facing financial trouble and improved transparency on the interest rates customers pay on their debts.
However, as Cliff D’Arcy highlighted, although these measures will help many customers to manage their debts more successfully, credit card companies will undoubtedly look to other ways to claw back their losses, such as re-introducing annual fees.
Added to this is the startling fact that according to our latest research, a quarter of us don’t even know how much interest we pay on our credit cards and loans.
After all, here at the Fool we always tell you the advantages of taking out a 0% credit card, but why? How much could your debt end up costing you if you don't bother to get one - or if you can't get one? Is it really so bad?
Minimum payments
Here’s a quick illustration of how a credit card debt of £1,000 and an APR of 18.9% could potentially escalate if you only paid the minimum payment each month, and how topping it up with extra funds could make a huge difference:
Minimum payment (2%), plus an additional payment of: | Time taken to pay off debt | Interest paid |
|---|
£0 | 33 years, four months | £2,769.10 |
£10 | Six years, five months | £576.53 |
£25 | Three years | £262.85 |
£50 | One year, seven months | £135.02 |
£100 | Ten months | £65.13 |
And here’s the same scenario for a debt of £2,500:
Minimum payment (2%), plus an additional payment of… | Time taken to pay off debt | Interest paid |
|---|
£0 | 50 years | £7,852.38 (!!) |
£10 | 13 years, five months | £2,769.26 |
£25 | Six years, nine months | £1,453.60 |
£50 | Three years, nine months | £807.90 |
£100 | Two years | £421.13 |
As you can see, the more you pay off each month on your credit card, the quicker and less expensive it is to borrow on your card.
Obviously, the ideal amount you’d want to pay off is the entire sum, which would mean you’d never pay a penny in interest. But not everyone can afford to do this every month, making the ‘ideal’ situation far from reality for many people.
However, I want to stress that the more you can pay off, the better. Even relatively small amounts can make a massive difference.
For example, if you racked up £1,000 on a credit card with an APR of 18.9%, it would take you over 33 years to pay it off and an extra £2769.10 in interest if you only made the minimum payment each month. This compares to just 10 months and £65.13 in interest if you can afford to throw an extra £100 a month at the debt.
So effectively, paying an extra £100 a month you will save more than £2,700 in the long run - and more than 32 years of debt repayments!
And bear in mind that's just on a £1,000 debt. The more debt you have, the more it will cost you. With £2,500 of debt racked up on the same credit card, only making the minimum payment means it would take you a startling 50 years to pay your debt off.
On top of this, you’d pay £7,852.38 in interest. That’s three times the original debt in interest payments alone!
(To figure out exactly how long it would take you and cost you to pay off your credit card debts, check out this credit card debt calculator.)
Every little helps!
So, the message may sound rather like an Oxfam appeal, but extra payments of just £10 a month would - in the end - save you a massive £5,083 in interest on a debt of £2,500. That’s enough to buy a decent second hand car. Food for thought indeed.
So that’s how minimum payments can affect the time taken to pay of your debts, but what about your APR?
APRs are often overlooked in terms of how they can affect your debt, and while we’re seduced by the prospect of 0% balance transfer offers, the rate of interest you’ll pay when your introductory offer expires can prove crucial.
So, as an illustration of how your APR could affect your debts, here’s how the interest could rack up on a £2,500 credit card bill depending on your APR, taking into account payments of £100 a month:
APR | Time taken to pay off debt | Interest paid |
|---|
12.9% | Two years, four months | £365.83 |
14.9% | Two years, four months | £437.17 |
18.9% | Two years, six months | £593.48 |
27.9% | Two years, 10 months | £1,053.91 |
As you can see, although there is a less significant impact on the time taken to pay your debt off, the APR on your credit card could make a significant difference in the amount of interest you end up paying overall.
For example, the difference in cost between a credit card with 12.9% and 18.9% APRs during the time taken to pay it off is £227.65.
It’s not exactly rocket science, but the costs get higher as the APR rises, and the difference between interest payments for a credit card with 12.9% and 27.9% APRs is £688.08 - enough for a decent holiday.
Higher APRs approaching 30% are normally associated with credit cards for people with less-than perfect credit ratings, or store cards. If you’re not careful, borrowing using one of these could end up costing you a lot more than you bargained for.
If you can, avoid borrowing using one of these cards at all costs. In fact, the only time when you should apply for one is under exceptional circumstances, such as the reason Jane Baker highlights in this excellent article.
The best cure for credit card debts is to transfer them onto a 0% credit card which will reduce your overall interest payments significantly. The Virgin Money MasterCard is the current market leader, giving you an balance-busting 16 months interest free on all balance transfers (a 2.98% fee applies).
If you want some handy hints on how to save more of your income, Donna Werbner has a few Foolish gems to start you off. Remember, a little goes a long way. After all, even if you start small, it will still set you on the road to being debt-free.