Credit debt can hang around for years – here’s why you shouldn’t just make minimum repayments.
25 November 2016
In June 2016, credit card debt in New Zealand totaled a staggering $6.49 billion. That’s an average of $1,500 for every single person in the country. When you think about it, that’s a fair bit of debt that we could do without.
Credit cards have become a key tool for helping us manage cash flow, especially around peak spending times like Christmas, or when the kids need new school uniforms.
Let’s face it, credit cards are also very convenient. You can use the bank’s money to make purchases on a credit card throughout the month. Then, where your card has an interest free period, as long as you pay the full amount owing by the due date, you have had the use of the bank’s money for free as no interest is charged.
The truth is, there’s nothing wrong with having a credit card, however things unravel a little bit when it isn’t managed properly.
So what is the trap with credit cards?
Credit cards often have higher interest rates than other loans. If your card has an interest free period and you are paying it in full at the end of the month it doesn’t impact you, but as soon as the balance caries over from month to month, these interest charges can really add up.
Added to this, if you think that making the minimum payment listed on your statement each month will be enough to pay it off over a reasonable term, you may have a credit card debt that stays with you for years.
How is the minimum payment calculated?
The required repayments on credit cards are often quite open ended, as it is not based on repaying the debt in a set amount of time.
This is quite different to home loans and personal loans that are set up with principal and interest repayments. Here the repayments are set at the start and are calculated so that each payment covers the interest for the month plus the amount of principal that is needed to ensure that there is nothing owing by the end of the loan term.
So, for example, if you have a five year, $5,000 personal loan, making your set repayments will mean that it is paid off and you will be debt free in five years.
Credit card repayments on the other hand are calculated each month and can range anywhere from 2% to 5% of the amount owing at the time, or a minimum dollar amount, which can be as low as $5.
Each time you make a minimum repayment, a large proportion can go towards paying the interest for the month, with only a fraction going towards the principal (the exact amount will vary depending on your credit provider’s repayment rules). Worse still, interest is calculated on a monthly basis so the repayment will continue to fall as it is calculated on what you currently owe.
In the end, it can end up costing you tens of thousands of dollars in interest. Using an online credit card repayment calculator to crunch the numbers, we found that paying the minimum monthly amount on a $10,000 credit card debt, at 18% interest; borrowers would pay $36,332 and it would take more than 43 years.
Credit debt shouldn’t hang over your head for years and years, so it’s important that when you use your credit card, you’ve got a way to pay it off quickly. Here are some of top tips on how to stay on top of credit card debt.
Don’t spend more than you earn
It may seem simple, but spending more than you earn is the easiest way to rack up expensive credit card debt. If you are going to buy something on the credit card, make sure you can pay it off straight away or at least at the end of any interest free period.
If you have a balance carrying over from month to month and you are going backwards, perhaps it’s time to make some tough decisions. Potentially you may choose to temporarily stop using the card and use cash instead, until the amount owing is paid off.
Those bargains at the Boxing Day sales may end up being very expensive if you consider the interest you may be paying.
Keep tabs on your card balance
Don’t wait until you get your statement to find out how much you owe. With internet banking, you can check your balance regularly. If the balance is creeping up and is more than you know you can repay easily, you may think twice about purchasing items that you don’t want straight away.
Don’t let Christmas get out of control
It can be hard to keep on top of finances over the silly season as things like presents, parties and taxis increase our spending dramatically. So, to make sure things don’t get out of control, read our blog on how you can learn from your past spending mistakes here.
Pay at least double the minimum payment
If you are paying off a credit card debt, don’t despair. Pay as much as you can each month and try not to build up any more debt until your credit card is under control. As a minimum, ensure that you pay at least double the minimum payment.
You can also use a financial repayment calculator to work out how much you would need to pay to pay it off in a set period of time. Use a calculator like this to work out how much this would be.
Create your own financial calendar
Most people have no issue creating social or work calendars, but when it comes to finance this is far less common. You should plot your goals onto a timeline and continually adjust this according to your progress. Computer or mobile application calendars are perfect for this, as they’ll provide reminders to keep you on track.
When people find themselves struggling to pay off multiple debts, their first reaction can be to just keep peddling harder in the hope of coming out the other side. But that doesn’t always work out.
Another option is to consolidate debts into a personal loan with a lower overall interest rate. You can also increase your home loan if you have equity in your property so that you can pay out the smaller debts.