Avoid the minimum payment trap
Taking out a credit card can be a convenient solution for your circumstances, but credit cards can also lead to avoidable extra debt if you do not manage your repayments well. Credit cards with high-interest rates can make your outstanding debt escalate if you are not paying the full amount off each month.
It can be very tempting to take out a credit card and then arrange to pay the lowest possible amount off the lender allows. However, by paying the minimum payment on a credit card, it could take many years to pay off the debt.
What is a minimum repayment?
When you take out a credit card with a lender, you will set up a direct debit for repayments and you will usually have a few different repayment options, which will be:
- To pay the full outstanding amount off
- To pay a set amount, such as £100 each month
- To pay the minimum amount as set by the lender
The best way to keep your interest fees as low as possible is to pay the full outstanding amount. If you cannot afford to do that, then you should opt to pay as much as you can afford, rather than selecting the minimum repayment amount. The minimum repayment amount will depend on how much outstanding balance you have but will usually be a percentage of around 1% plus interest.
The interest rates on credit cards vary greatly, so when you are considering applying for a credit card, you should try to avoid one with a high interest rate, as you could end up paying a great deal more in interest than you would with a lower interest rate.
Minimum repayment example
If you had a credit card with an 18% annual interest charge and a minimum repayment of 1% plus interest, it would take 24 years to pay off a debt of £2,000 and you would pay total interest of £2,593 on top of the £2,000 borrowed.
If you chose to repay a fixed amount of £100 each month instead of the £20 minimum repayment, you would repay the debt in two years and would pay £359 in total interest (so an overall repayment of £2,359 in total, instead of £4,593).
From these examples, you can see the significant difference in the length of time to repay and the extra amount of interest, so if you had an even higher interest rate, you would be facing even further avoidable interest charges.
Lenders make profits through the interest rates that they charge and when customers only pay off the minimum repayment each month, the bank will make more money.
Often, credit card holders are unaware of the long-term financial impact of only paying the minimum repayment each month. This scenario is referred to as the ‘minimum repayment trap’, where the credit card holder ends up repaying significantly more than they borrowed and, in many cases, over double the amount that they borrowed.
It is worth exploring all your options before you take out a credit card, for example, a credit union loan could save you from repaying high interest fees.
Credit unions are not-for-profit organisations, so unlike banks, they do not offer options such as minimum repayments that are not in the best interests of the borrower.