Credit Card
Minimums
The Dollar Stretcher
by Gary Foreman
gary@stretcher.com
Dear Dollar
Stretcher,
I recently got approved for a credit card that was
offering a 3.9% interest rate as a promotional offer. I
switched a balance of $6,000 over from a card that was
charging me 24.99% interest. The minimum monthly payment
on the old card was $119 but the minimum payment on the
new card is $126. I thought this higher minimum payment
was odd considering it was supposed to be a lower
interest rate. When I called the company they told me
that their minimum payment is calculated by figuring 2.1%
of the balance. I am not quite sure I understand how the
higher rate card calculated the minimum payment,
something called a daily periodic rate. How much, if any,
am I saving by switching to this new card? I was
wondering if you might help me understand this better.
Gwen E.
Gwen has actually
asked three questions. And, based on other similar
questions that come in, she's not alone in getting
confused with her credit card bill. Let's see if we can't
shed some light on the subject.
First, we need to
think about what's actually happening in her credit card
account each month. She starts each month with a
beginning balance. In Gwen's case that's the $6000 that
she mentioned. To that amount will be added any new
purchases made with the card during the month. She'll
also add the interest charges for borrowing the money.
From that amount is subtracted the payment that Gwen
sends in. The result is the ending balance. This month's
ending balance is next month's beginning balance. If that
seems confusing, just think of it one piece at a time.
Our next step is
to define some of the terms that Gwen sees on her
statement. The first one is the interest rate. To
simplify, the interest rate is the amount of money that
Gwen will pay for the privilege of borrowing the account
balance. It's stated as an annual percentage of the
amount owed. In Gwen's case she was paying 24.99%.
That's were the
'daily periodic rate' comes in. That's the amount that's
charged each day for borrowing money. A 24.99% annual
rate would be .06847% each day. So if your account had a
balance of $6,000 today, you'd pay $4.108 in interest
($6,000 x .0006847) per day. If your balance never
changed, you'd pay $1,500 each year.
Don't get all
excited over the math. You can get a pretty good estimate
of your interest expense by taking your ending balance
and multiplying it by 1/12 of the annual interest rate.
In Gwens's case she's paying 2.08% each month (24.99% /
12 = 2.08%) or $124.80 ($6,000 x .0208) in interest each
month. Now, let's examine why the minimum payment didn't
go down. The reason is simple. The minimum payment isn't
based on the interest rate. It's calculated using the
account balance. So lowering your interest rate won't
affect the minimum due each month. Typically, you'll find
that the minimum payment is about 2% of the outstanding
account balance.
Finally, on to
the third question. How much is she saving by switching
cards? There's really two ways to look at how much she's
saving. The simplest way is to compare how much she's
spending in interest each month. At 24.99% interest, that
$6,000 balance was costing her $124.80 each month. At
3.9% the interest expense is only $19.50 per month
($6,000 x .039 / 12). That's a saving of $105.45 per
month.
Another way to
figure the savings is to consider how long it would take
to pay off the balance. It's interesting to note that
under the old card Gwen would never have the balance paid
off even if she cut up the card today. Each month the
interest added to the balance ($124.80) was more than the
minimum payment ($119). So she could keep making that
monthly payment the rest of her life and never dent the
account balance. The account has been set up so that
she'll be paying forever. Talk about pouring money down a
hole!
Gwen will save
some with the new account. But, she'll still be paying
off that balance for quite some time. She didn't say how
long the intro rate applied. For illustration purposes we
assumed that it was good for 12 months and then the
account reverted to a more normal 16% annual rate. We
also assumed that the minimum monthly payment was 2% of
the account balance or $15 (whichever was greater).
What you're about
to read may cause you to rethink how you use your credit
cards. If Gwen pays the minimum each month and never
charges another dollar to her account it will take her
375 months (that's 31 years) to pay off the $6,000
balance. She will have paid just a shade over $9,000 in
interest payments during that time. So it will have cost
her $15,000 in payments to borrow $6,000. Or to put it
another way, that's like buying a $50 blouse and paying
$125 for it!
The bottom line
is that Gwen was correct to transfer the account. As a
general rule it's always better to pay a lower interest
rate. The only caution is to make sure that there's no
transfer fee or cash advance charge that will eat up the
savings from the lower rate.
Many consumers
are confused by the mumbo-jumbo that goes into
calculating their balance. Sometimes it appears that the
credit card companies try to make their statements hard
to understand. Their view: "Just keep sending in
those minimum payments, please! And don't try to figure
out what's going on."
What lessons can
Gwen learn? First, your minimum payment isn't designed to
pay off your debt. Second, lower interest rates do save
you money. And, finally, that running a credit card
balance makes everything you buy on that card very
expensive.
Thanks to Gwen
for asking a fascinating question. Hope she's able to pay
off that account before the promotion rate ends.
Gary Foreman is
the Editor of The Dollar Stretcher website www.stretcher.com. You'll find the web's
largest collection of free time and money saving
articles. There's also a free
weekly email newsletter that will help you live better on
the money you already make!
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