The danger of minimum repayments

If you only repay the minimum on your credit card you could end up spending decades in debt, says consumer champion Sam Dunn.

It’s the stuff of Alice’s Adventures in Wonderland – apply for a credit card, digest the small print for “minimum repayment only” and gawp as your debt mushrooms to ceiling-busting proportions.

What follows is fantastical but for all the wrong reasons. Imagine you’ve built up £2,000 on a credit card with an APR of 15 per cent and, to reduce your outgoings, decide to make only the monthly minimum repayment.

Using a bank’s typical minimum repayment calculation that asks you to pay the greater of 1 per cent of the balance plus interest or £5, it would take you a stonking 23 years and six months to repay £2,176 of interest - on top of your original £2,000 debt.

Well how about that - a near quarter century of repaid interest that costs you more than your original balance. There’s nothing minimum about that. Fantasy figures aside, the bleak reality is that minimum repayments – easy to pay and manage - are also hideously easy to forget and overlook.

A clever trap

And no wonder: it's in companies’ interests to set repayments at ridiculously low levels that keeps you indebted for great stretches at a time. About one in eight cardholders make only the minimum repayment and while many families will use it as a lifeline allowing greater affordability - especially at times of financial stress - it is also a clever trap.

When your repayment is so small, it can swiftly slip out of your financial sights and shortly slide out of mind. Then, when conveniently below the radar, all it needs is time to let the interest payments pile up and do the real damage.

New rules introduced during this year’s revamp of the Lending Code have sadly done little to discourage this. For anyone now taking out a credit card, the minimum repayment must be at least 1 per cent of your outstanding balance plus interest and any default charges or annual fees from the same month.

Brand new rules

Previously, many card calculations didn’t have to factor in a 1 per cent threshold and so could take even more of the cardholder’s repayment as interest rather than on reducing the actual debt. While it might not sound like much of a change, it is an improvement of sorts as more of your debt is now repaid.

But it doesn’t change the mechanism of the trap: because you pay a percentage of your outstanding debt rather than a fixed sum, as your overall debt falls so does your monthly repayment. Canny, eh?

However, at least another change better addresses the deeper problems of entrenched minimum repayment makers. The new regulations also insist that card companies must now contact cardholders who regularly make only the minimum to warn that this will cost them much, much more in the long term.

This will hopefully prove a useful wake-up call for many unaware that their choice of debt repayment is saddling them with horrendous long-term interest payments.

Take action yourself

Yet there’s plenty that cardholders stuck on the minimum repayment can do to limit long-term damage to their personal finances. If it’s affordable, the best step to take is a fixed monthly sum to pay down the card debt – this way, real inroads can be made into what’s owed rather than simply chipping away slowly.

It doesn’t have to be enormously high sum, and certainly not one that imperils other finances, but if possible it's worth aiming for a sum equivalent to at least 5 per cent of the outstanding debt – and ideally 10 per cent.

Alternatively, if the debts are held on an expensive credit card, users with a decent credit score could transfer to a 0 per cent balance transfer card and reduce the overall cost of their long-term debt.

Even better, if you’re not grappling too hard with your personal finances and have some savings you can tap into, using cash that’s unlikely to be earning more than 3 or 4 per cent in a savings account to pay down any debt costing more than this – and many cards will be at 18 per cent and above – will make sound financial sense. 

Comments

[Mandurah Real Estate]

Besides, paying only the minimum payment amount, it only increases the time when one will be able to cover all the debt and it makes the payment of the debt longer and expensive. It's a headache actually.

[Richard Lock]

I feel very strongly that, whilst people should accept greater responsibility for their actions, the financial sector should also be forced to accept far greater responsibility for their part in the creation of huge personal debts. One step in this direction would be to put a cap on the amount of time credit card balances can be maintained at certain levels. Certainly I agree with you that a higher target for repayments should be set by the individual but I feel that that this is something the credit card companies could and should do.