Avoiding the Minimum Repayment Trap

Credit cards can sometimes be confusing, because unlike mortgages and personal loans the amount you repay each month is largely up to you. The more you pay back, the quicker you clear your debt. There is one rule: repay a minimum amount each month, or you will incur a penalty charge. Fortunately, this minimum repayment is usually very low, often around two percent of the outstanding balance or five pounds: whichever is higher.

Repaying the minimum amount sounds attractive, because you can spread the cost over a longer period and make large purchases more affordable. However, if you only ever make the minimum repayment it will take you a lot longer to repay your debt, and in the end cost you more because of the accumulated interest. You should always aim to repay your credit card debt as soon as possible, because the longer your debt lingers the more it costs you overall. If you require a long period to pay off a large amount there are other financial options more suited to this purpose, which will typically cost you less. For more details see Personal Loans.

It is critical that you do not pay the minimum repayment amount for a long period of time. The minimum repayment is designed to work in tandem with compound interest and make your card provider as much money as possible (for details of compound interest see Interest Rates). For example:

• Mike borrows £4,000 on his credit card. He no longer uses the card, because he wants to clear this debt.
• Mike can only afford to make the minimum repayments on his credit card: 2.25% or £5, whichever is higher. 2.25% of £4,000 is £90 – Mike must pay ninety pounds the first month.
• However, although Mike is making repayments of around £90 a month he is also being charged interest by his card provider.
• The annual compound interest rate on his card is 17% APR. This equates to a basic (non-compounded) monthly interest rate of 1.317% which is £52.68 of interest each month.
• Mike's debt is only reduced by £90 minus £52.68 = £37.32 in the first month.
• Each month the minimum repayment will reduce slightly as the total outstanding balance decreases, and the new interest charged will also reduce accordingly.
• However, the effect of compound interest (whereby you are charged interest both on your outstanding balance and on the interest earned in previous months) means that the debt is only reduced very slowly.
• If Mike makes minimum repayments on his £4,000 debt, it will take him over thirty years to clear the debt and he will pay more in interest charges alone than he ever spent on his card.

The APR (or Annual Percentage Rate) is not simply twelve times the basic monthly interest rate. Interest is also charged at the monthly rate on interest earned in previous months. Essentially, the interest you earn also earns interest. All the interest earned compounded with all the interest earned on that interest adds together to equal the APR. If the interest were not compounded, that is, if the interest itself did not earn interest, the annual interest rate would be a 'non-compounded equivalent rate'. This would be the basic monthly interest rate multiplied by twelve. In Mike's case, this would be 1.317% x 12 = 15.8 %. For more details see Interest Rates.

Mikes debt reduces extremely slowly; Mike makes minimum repayments paying off a small amount of his overall debt and the overall debt is reduced each month by a small amount. However, over time less and less of Mike's debt is actually paid off. There are two reasons for this. The first is that as the outstanding debt decreases so does the minimum repayment, because it is always a fixed percentage of the outstanding balance. Secondly, as the minimum repayment decreases, less and less of this repayment goes towards paying off the debt and more and more goes towards paying off the compounded interest charged.

This table helps to explain:

If you only ever repay the minimum amount, the amount of debt that you pay off decreases each month, which prolongs the time taken to pay off the total credit card balance.

Fixed Payment
There is a very simple solution to this spiral of interest and debt. Provided you do not make any more transactions with your card, you can significantly reduce the time it takes to clear your debt if you keep your repayments constant. If Mike had repaid ninety pounds each month instead of the 2.25% minimum repayment, he could have cleared his debt in just five and a half years. This is because each month, more and more of his £90 repayment would go towards repaying the debt rather than just paying off the interest. As the outstanding balance is slowly paid off, the interest charge becomes less and less each month and the debt can be cleared more quickly.