The True Cost Of Credit Card Debt
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Today, as a personal favour, I would like to ask all of you with credit card debt to put off one -- or all -- of the following:
1)Washing the dishes.
2) Going to the gym.
3) Starting a diet.
But whatever you do, please don't put off dealing with your debt any longer.
Last week, in Credit Cards Can Save You From The Credit Crunch, I wrote about why it is vital to get rid of your debt in today's uncertain economic climate. I also looked at how 0% balance transfer cards can help you to pay off credit card debt in the cheapest way possible.
But the trouble is, applying for a new credit card involves time, effort and hassle.
And I suspect some of you reading this are thinking: "Why should I bother? Why should I scrimp and save to pay off my debt over the next year or two? As long as I can afford to meet the minimum payments required, then it's no big deal to be in debt."
You may think this argument has a certain logic to it.
But for me, it makes no sense. I think some examples would help.
Minimum Payments
Let's look at what would happen if you only met your minimum payments each month, no more.
Your card provider may expect you to pay either £5 a month, or 2% of your balance, whichever is the greater amount.
Or alternatively, particularly if the card has been issued by MBNA, it may expect you to pay either £25 a month, or around 3% of your balance, whichever is the smaller amount.
This may seem like a tiny, technical difference, hidden in the small print. But it can cost you hundreds of pounds.
Here's what would happen to your credit card debt if you paid £25 every month, and your card charged you a typical APR (15.9%).
First, let's look at it over one year:
Balance
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Interest Rate On Credit Card (APR)
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Payment per month
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Total amount outstanding after one year
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£1,000
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15.9%
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£25
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£874
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£1,500
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15.9%
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£25
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£1,460
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£2,000
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15.9%
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£25
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£2,021
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£3,000
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15.9%
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£25
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£3,193
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As you can see, if you only pay the minimum payment for a year, you'd have paid off £136 of your debt. But during this time, you'd have paid £300 towards your card provider. That's £164 you've wasted on interest payments.
And if you started off with £3,000 of debt, your debt would have grown by £193 - even though you had paid £300 towards it. That means you're £493 worse off at the end of the year.
Remember, throughout this entire year, you've been faithfully paying £25 a month. And you haven't spent a penny on that card during that entire time.
Even if your card provider forced you to pay a higher minimum payment, you would still waste hundreds of pounds in interest.
Balance
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Interest Rate On Credit Card (APR)
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Payment per month
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Total amount outstanding after one year
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£1,000
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15.9%
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2% of balance (£20, initially)
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£919
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£1,500
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15.9%
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2% of balance (£30, initally)
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£1,379
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£2,000
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15.9%
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2% of balance (£40, initially)
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£1,839
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£3,000
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15.9%
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2% of balance (£60, initially)
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£2,759
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In this example, if you started off with a £3,000 balance, you would only have managed to reduce your debt by £241, despite paying £702 to your card provider over the course of a year. So, effectively, you've wasted £461.
You could avoid all this by switching to a 0% balance transfer card and increasing your monthly payments, as follows:
Balance
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Payment per month
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Total amount outstanding after one year
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Amount you have saved by paying off your debt
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£1,000
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£83.34
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£0
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£153
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£1,500
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£125
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£0
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£230
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£2,000
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£166.67
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£0
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£307
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£3,000
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£250
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£0
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£461
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If those payments seem a bit steep - and let's face it, a jump in your payments from say £60 a month to £250 could be difficult to manage - then you could decrease the monthly payments by 50% (from £250 to £125) and move your balance to another 0% balance transfer card in 12 months' time.
What! More switching!
I'm guessing some of you will not exactly be taken with that last piece of advice. Not only does it involve mores switching, you will still have to substantially increase your payments every month.
But let's face it, if you don't want to step up your payments this year, you'll want to do it even less next year, when your debt will be bigger and the amount you need to pay every month will be larger.
So, let's take a look at what would happen if you didn't change your approach this year, and simply carried on making those minimum payments.
Let's also assume you didn't read the small print and took out a card where the minimum payments were either £25 a month or 3%, whichever was the smaller amount.
What would your balance look like after five years?
Balance
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Interest Rate On Credit Card (APR)
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Payment per month
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Total amount outstanding after five years
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Amount you would have saved by paying off your debt this year
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£1,000
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15.9%
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£25*
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£372
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£678
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£1,500
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15.9%
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£25*
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£1,044
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£1,434
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£2,000
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15.9%
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£25*
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£2,151
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£1,651
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£3,000
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15.9%
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£25*
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£4,365
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£2,865
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* Or 3%, if it is the lower payment
As you can see, if you owe more than £1,500, a £25 monthly payment is too low an amount to keep up with the interest rate you are paying.
So your debt is getting bigger, instead of smaller.
In this example, from an original £3,000 balance, the debt has mushroomed into £4,365 after five years - swallowing up £1,500 of payments along the way.
Clearly, the debt is spiralling out of control at this point.
But let's say you didn't increase your payments even after five years. Here's what would happen to your debt over the next 25 years:
Balance
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Interest Rate On Credit Card (APR)
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Payment per month
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Total amount outstanding after 25 years
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Extra amount you owe, on top of your original debt
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£1,000
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15.9%
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£25*
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£0 (paid off after 12 years, 8 months)
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N/A
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£1,500
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15.9%
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£25*
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£0 (paid off after 18 years)
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N/A
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£2,000
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15.9%
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£25*
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£11,009
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£9,009
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£3,000
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15.9%
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£25*
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£84,081
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£81,081
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* Or 3%, if it is the lower payment
Now that is truly scary. The figures show that, if you only paid £25 a month on your card for the next 25 years, even a relatively small debt of £2,500 will grow to almost £11,009, plus you would have paid £7,500 to the card provider over those years.
Meanwhile, £3,000 of debt will swell to £84,081, despite the £7,500 of payments.
And that's assuming the interest rate doesn't ever increase beyond 15.9% and you don't spend a penny on that card until 2031!
Good news......
But there is some good news. It's easy to ensure your credit card debt doesn't mushroom in the way I have described. Read my article on Credit Cards Can Save You From The Credit Crunch for a details on what to do and how to do it.
Don't delay. Leave the dirty dishes unwashed for 24 hours! Because if you don't deal with your debt today, you will find it a hell of a lot harder - and more expensive - to deal with tomorrow.
PS. If your credit record isn't great, you may not be able to get a 0% balance transfer credit card. But don't despair! Visit our Dealing With Debt discussion board where kind Fools can give you advice on how to improve your debt situation.
> Get a 0% Balance Transfer Credit Card via The Fool
Editor's note: Apologies for the incorrect 'teaser' used with this article. That was an unfortunate error which has now been corrected.
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