The prospect of a low monthly minimum payment is enticing, especially to young borrowers who are relatively new to credit cards and long-term loans. There are major dangers that come with reduced payments, however, that can leave you in a much worse position than if you had simply paid a little more on a monthly basis.
It’s important to first understand how interest accrues, and it’s a fairly simple concept. If you have a loan or credit card that has an interest rate of 15% APR, it means that you’ll be charged 15% of the total loan each year. So if you owe $5,000, for example, 15% of that would be $750 in yearly interest.
Now, let’s say that your creditor sets your minimum monthly payment at $70. If you paid that $70 every single month, how much would that be in the first year? $70 multiplied by 12 months is $840. With minimum payments, you’d pay $840 and $750 of that would go just to interest.
That leaves $90 — you’d have made $840 worth of monthly payments, but would only have knocked $90 off of the original $5,000. At that rate, it’ll take 15 years to pay off the loan, and you’ll end up paying back $12,600 — well more than double what you borrowed. Not a good idea.
Now, let’s take that same scenario — $5,000 debt with 15% APR — but apply $100 each month instead of $70. Going this route, you’ll pay off the loan in about six-and-a-half years, end up paying back roughly $7,900. Bump the monthly payment up to $125, and you’ll pay it back in four-and-a-half years for under $7,000.
So a quick payment recap … $5,000 debt at 15% APR:
$70/month payment = 15 years of payments = $12,600 total
$100/month payment = 6 ½ years of payments = $7,900 total
A minimum monthly payment is just that — a minimum. It’s far from a suggested monthly payment. In the previous case, $30 per month made a difference of more than 10 years and almost $5,000. It’s a small sacrifice to make month-to-month, but a massive benefit in the long run.
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