What are Minimum Payments?
Almost everyone knows about minimum payments — they’re the amount you have to pay your credit card company (or lender) each month — but few of us stop and think about how those monthly amounts are calculated or understand the “myth of minimum payments.”
In fact, you probably don’t know that minimum payments are strategically calculated to always be about 2% of your total balance. Why two percent? Because that’s the amount that is most likely to maximize profits (i.e. your interest payments) to the company loaning you the money.
Yep, that’s right: the bank doesn’t always have your best interests in mind. Who would’ve thought?
So how does it work? Well, you might think that paying 2% of your balance each month would result in paying 24% off in a year (2% x 12 months = 24%). However, since the 2% amount is calculated on a monthly basis and since interest is added to your balance every month, your minimum payments won’t ever pay off 24% of your balance in a single year.
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The Sneaky Part
Let’s use an example to show why your balance can stay the same (or perhaps even grow) while you pay all those minimum payments: If you have a credit card with an interest rate of 18%, which is pretty common, and a balance of say, $10,000, your minimum payment would be $200 and your interest for that month would be about $150. So while you think you’re paying off $200 of your debt, you’re really only paying $50.
Multiply that by twelve months, and you’ll pay about $1800 of interest while only making a dent of $600 in your balance.
What’s even worse is that if you have an extremely high interest rate — of 24% or more — then paying your minimum payments will actually make you fall deeper in debt each month. (If you don’t believe it, take a quick look at this funny/scary infographic)
Now you can understand the myth of minimum payments: the idea that those payments are intended to help you pay off your balance is false.
How Psychology Affects Your Payment Behavior
Not only are the minimum payments not enough to get your balance paid off, but they also have a psychological affect on you.
A recent research study concluded that the amount of your minimum payments can influence how much of your balance you decide to pay off each month. Specifically, according to the Wall Street Journal, the study looked at how people’s behavior changed when they saw a specific number marked down as a required minimum payment on their hypothetical credit card bill:
A random sample of 481 Americans saw a mock credit-card statement showing a balance of $1,937, and an annual percentage rate of 14%. Some people saw no further information, while others were informed that a minimum payment of 2% of the balance was mandatory.
What they found is that people who did not see any minimum payment number desired to pay a higher amount of their balance — significantly more than 2% — whereas people who were shown the minimum payment number were inclined to pay closer to 2% (meaning they’d be in debt longer).
We can speculate that this is because the 2% amount acts as an anchor in determining what you consider a “reasonable” payment to be.
Maybe you had planned to pay off the balance in 6 months, but since the bank is only asking you for 2% on your credit card statement, you figure that’s the right course of action. After all, they’re your bank, they must know what’s appropriate for you, right?
And that’s how you become the proverbial frog in a pot of boiling water. You wouldn’t allow the bank to take $1,000 or $5,000 or $10,000 in interest payments from you in one day, but by convincing you to succumb to the minimum payments myth they quietly take that much from you over the course of several years. It happens so gradually that you might barely notice until it’s too late.
What You Can Do About It
You need to fight this inclination to pay only minimum payments. That’s why ReadyForZero always shows you how much you’ll pay in interest, given your plan, and encourages you to make extra payments to zero out those balances as fast as possible.
And we’ve been thrilled that it has been working for people. You can read some of the profiles we’ve done of ReadyForZero users who are paying off their balances.
So no matter what your debt situation is, make sure you find a way to fight back against the myth of minimum payments. That way, you too will be on your way toward financial freedom!
This article is part of our Credit Card Debt Resource Center. If you’re looking for additional information about credit card debt, be sure to pay a visit!
Image credit: Richard ‘Tenspeed’ Heaven