Credit Card Minimums

by Gary Foreman

Dear Dollar Stretcher,
I recently got approved for a credit card that was offering a 3.9% interest rate as a promotional offer. I switched a balance of \$6,000 over from a card that was charging me 24.99% interest. The minimum monthly payment on the old card was \$119 but the minimum payment on the new card is \$126. I thought this higher minimum payment was odd considering it was supposed to be a lower interest rate. When I called the company they told me that their minimum payment is calculated by figuring 2.1% of the balance. I am not quite sure I understand how the higher rate card calculated the minimum payment, something called a daily periodic rate. How much, if any, am I saving by switching to this new card? I was wondering if you might help me understand this better.
Gwen E.

Gwen has actually asked three questions. And, based on other similar questions that come in, she's not alone in getting confused with her credit card bill. Let's see if we can't shed some light on the subject.

First, we need to think about what's actually happening in her credit card account each month. She starts each month with a beginning balance. In Gwen's case that's the \$6000 that she mentioned. To that amount will be added any new purchases made with the card during the month. She'll also add the interest charges for borrowing the money. From that amount is subtracted the payment that Gwen sends in. The result is the ending balance. This month's ending balance is next month's beginning balance. If that seems confusing, just think of it one piece at a time.

Our next step is to define some of the terms that Gwen sees on her statement. The first one is the interest rate. To simplify, the interest rate is the amount of money that Gwen will pay for the privilege of borrowing the account balance. It's stated as an annual percentage of the amount owed. In Gwen's case she was paying 24.99%.

That's where the "daily periodic rate" comes in. That's the amount charged each day for borrowing money. A 24.99% annual rate would be 0.06847% each day (24.99 divided by 365 days in one year). So if your account had a balance of \$6,000 today, you'd pay \$4.108 in interest (\$6,000 x 0.0006847) per day. If your balance never changed, you'd pay \$1,500 each year.

Don't get all excited over the math. You can get a pretty good estimate of your interest expense by taking your ending balance and multiplying it by 1/12 of the annual interest rate. In Gwens' case she's paying 2.08% each month (24.99% divided by 12 = 2.08%) or \$124.80 (\$6,000 x 0.0208) in interest each month.

Now, let's examine why the minimum payment didn't go down. The minimum payment isn't based on the interest rate. It's calculated using the account balance. So lowering your interest rate won't affect the minimum due each month. Typically, you'll find that the minimum payment is about 2% of the outstanding account balance.

Finally, on to the third question. How much is she saving by switching cards? There's really two ways to look at how much she's saving. The simplest way is to compare how much she's spending in interest each month. At 24.99% interest, that \$6,000 balance was costing her \$124.80 each month. At 3.9% the interest expense is only \$19.50 per month (\$6,000 x 0.039 / 12). That's a savings of \$105.45 per month.

Another way to figure the savings is to consider how long it would take to pay off the balance. It's interesting to note that under the old card Gwen would never have the balance paid off even if she cut up the card today. Each month the interest added to the balance (\$124.80) was more than the minimum payment (\$119). So she could keep making that monthly payment the rest of her life and never dent the account balance. The account was set up so that she'll be paying forever. Talk about pouring money down a hole!

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Gwen will save some with the new account. But she'll still be paying off that balance for quite some time. She didn't say how long the intro rate applied. For illustration purposes we assumed that it was good for 12 months and then the account reverted to a more normal 16% annual rate. We also assumed that the minimum monthly payment was 2% of the account balance or \$15 (whichever was greater).

What you're about to read may cause you to rethink how you use your credit cards. If Gwen pays the minimum each month and never charges another dollar to her account, it will take her 375 months (that's 31 years) to pay off the \$6,000 balance. She will have paid just a shade over \$9,000 in interest payments during that time. So it will have cost her \$15,000 in payments to borrow \$6,000. Or to put it another way, that's like buying a \$50 blouse and paying \$125 for it!

The bottom line is that Gwen was correct to transfer the account. As a general rule it's always better to pay a lower interest rate. The only caution is to make sure that there's no transfer fee or cash advance charge that will eat up the savings from the lower rate.

Many consumers are confused by the mumbo-jumbo that goes into calculating their balance. Sometimes it appears that the credit card companies try to make their statements hard to understand. Their view: "Just keep sending in those minimum payments, please! And don't try to figure out what's going on."

What lessons can Gwen learn? First, your minimum payment isn't designed to pay off your debt. Second, lower interest rates do save you money. And, finally, that running a credit card balance makes everything you buy on that card very expensive.

Thanks to Gwen for asking a fascinating question. Hope she's able to pay off that account before the promotion rate ends.

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

Take the Next Step

• Use these Credit Card Calculators to find out: The true cost of paying the minimum, what will it take to pay off your current balance, whether a cash back or low interest card is better for you, how much you could save by transferring your balances, and more.
• Find out if you are heading for debt trouble. This simple checklist can help you determine if you are and point you in a better financial direction.

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