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How Paying Interest will Eat You Alive

Whenever you take out a loan or create some form of debt, you must pay interest. Interest is considered the cost of doing business. It compensates the lender for the use of the money. You can think of it as the rent you are paying for the use of the money.  The interest rate that you’re charged is based on the principal amount borrowed, on your individual credit score (your creditworthiness), the length of time and other factors.

Interest can become a problem for borrowers who take out a loan, use a credit card, or engage in other types of debt activity (i.e. payday loans) especially if you only make the monthly minimum payments. Often interest compounds so outstanding debt accrues (grows) additional interest. By making small or minimum payments it can result in a larger payment of interest than the original principal amount owed.

Thirty-nine percent of Americans carry credit card debt from month to month and in 2012, the average credit card debt among low- and middle-income households carrying credit card debt totaled $7,145, down from $9,887 in 2008. According to many credit counselors, you need to understand how debt works and how making minimum payments may not be in your best interest.

How Debt Works

Paying InterestExample:

If you apply for a credit card that has an annual percentage rate (APR) of 15 percent. Broken down, this becomes a daily rate of 0.00041% interest that is applied to any debt you amass, whenever your credit card carries a balance from the previous month . Let’s say the credit limit on the card is $10,000 and you have a $1 carried over from the previous month. You spend $9,999.00  and now have a credit card balance of $10,000 due.

Since the full amount does not have to be paid off right away, the daily APR rate of 0.041% begins to accrue on the outstanding balance. After day one, the balance grows to $10,004.10. Day two is $10,008.20; day three, $10,012.31; and so on. By the end of the month (30 days) the amount of interest grows to $123.73. If you had started with a zero balance and paid it in full at that point you would owe no interest because of the grace period, but because you had that $1 balance you owe $123.73 extra. If you pay only the  minimum you continue to owe interest on the unpaid balance and the accrued interest. If left unpaid, after a year, because of compounding the total debt outstanding would rise to $11,613.92, effectively moving the annual rate to 16% as opposed to 15%.

Paying Only Minimum Payments

People who aren’t very money savvy think paying the minimum is a cheap way to get stuff. After all they got $10,000 worth of stuff and they are only paying a little over $200 a month for it. But… remember that stuff is depreciating and the interest is mounting up.

The minimum payment is a percentage of the total balance and is set forth in the credit agreement and is determined by the card issuer. Usually this amount is a stated rate of 1% to 3%. Let’s say the stated minimum payment rate is 2% and you make the payments based on this amount toward the $10,000 credit card debt. This would amount to a payment of $202.47 at the end of the first 30 days. This creates a new balance of $9,921.26 on day 31. Continuing the trend of paying the minimum 2% of the balance at the end of the month results in a balance year-end of $8,931.27. Making the minimum percentage payment alone (with a payment of no less than $25) would take you 29 years and 8 months to pay the $10,000 back, incurring interest payments of $15,307 for a total payment of $25,307. This is almost the same as a 30 year mortgage! And you would have paid 2½ times what you borrowed. But at least with a mortgage you still have the house. Will you still have that $10,000 worth of junk you bought on your credit card 30 years later?  I doubt it!

A Sensible Solution to Managing Interest Payments

The best way to understand interest in order to manage it properly is to read loan and revolving credit agreements carefully. Your credit card statement, for example, provides a wealth of information, such as the number of years needed to pay back interest and the total amount of interest paid. You should always pay more than the stated minimum amount. Better yet, plan to pay your credit cards off in full every month (i.e. don’t buy it if you can’t afford to pay for it) and put the extra $15,307 in your pocket rather than the bank’s. Budget your purchases to pay back the loan or debt before it takes over your life and your finances.

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This article written by Lynn Lee, finance blogger.  When Lynn isn’t blogging, she enjoys sipping chai and relaxing in her garden.