The Minimum Payment Credit Card Trap

Total UK personal debt stood at £1.6 trillion at the end of July 2018, according to data from The Money Charity. This has risen from £1.5 trillion a year prior, working out as an extra £884 per UK adult.

The average total debt per household (inclusive of mortgages) was £58,658.

“Per adult, in the UK that’s an average debt of £30,636 or around 113% of average earnings.”

Based on July’s figures, the UK’s total interest payments on the personal debt over a 12 month period would have been £50 billion! That works out as:

  • An average of £137 million per day.
  • Households in the UK would have paid an average of £1,838 in annual interest payments over the last year – per person that’s £960 or 3.5% of average earnings.

According to the Office for Budget Responsibility’s March 2018 forecast, household debt is forecast to reach £2.3 trillion by early 2022. This would equate to an average household debt of £84,412 (assuming that the number of households in the UK remained the same between now and then).

Some pretty sobering statistics there regarding total UK personal debt which only seems to be heading in one direction, unfortunately. One of the main culprits, as always, is consumer credit and the ‘buy now, pay later’ mindset.

Credit Cards

On credit cards specifically, the money charity estimate that there is £72bn of outstanding credit card debt and rising.

The stress and anxiety this can cause are immeasurable. So, if you have a credit card with a sizeable balance and you are trying to ‘manage’ it, you need to take action. And if you think paying the minimum payment each month is doing ‘enough’ you have your head in the sand…

“Paying just the minimum is quite simply a mug’s game”

If you can avoid it, never borrow money on a credit card in the first place (unless you find one with 0% interest and if it’s not 0%, ensure you pay off the full amount each month). If used correctly, credit cards do have their place of course (think reward points, air miles etc) but they are one of the worst places to harbour debt.

That is because the vast majority of credit cards charge extortionate rates of interest for the privilege of using plastic. The Money Charity also suggests that the average APR for credit card debt in the UK is 18.35% – and that’s just the average!

I have seen other statistics which suggest the figure is nearer 23%. Either way, at these levels it’s a major, major problem!

The Minimum Payment Trap

To make matters worse, most credit cards providers only require you to meet a small minimum payment per month to avoid penalties (as if charging you double-digit interest was not enough of a penalty!)

This minimum payment is usually as low as 1 or 2% of the outstanding balance.

In fact, a quick scan of the current credit card offered by the UK’s leading high street banks suggests a minimum repayment of between 1.5 and 3 % is typical in today’s market.

So what exactly happens, if you only pay the minimum balance on a credit card carrying a punchy APR? Things get pretty scary is what happens!

The Average Example

The average UK credit card balance per household is £2,607 carrying an average APR of 18.35% according to The the Money Charity.

So let’s take that as our example and run the numbers to see what the ‘average’ person would face if they only meet the minimum payments. Again, other statistics I have seen suggest higher average balances and APR’s so, if anything, we are undershooting reality here.

Let’s say you owe the current UK average of £2,607 at a monthly rate of 1.53% and each month you meet a minimum payment that equates to 2.5% of the balance.

In month 1, that would be a repayment of £65, but just under £40 of this goes on interest charges. Each month, the minimum repayment will creep lower but it’s a long old slog to get to the end.

In fact, it will take you over 315 months (more than 26 years) to pay it off in full! In that time, you will incur over £3,666 in interest payments! And that’s without the other potential sneaky add-ons (think annual memberships for your fancy premium card or payment protection insurance).

Doing More Than Minimum

If you could afford to pay an extra £10 a month towards this debt, it would mean repaying it in a comparatively more favorable 124 months (just over 10 years) and you’d save yourself £1,725 in interest. In fact, if you could afford an extra £25 a month, you’d clear it in 70 months (just over 5 years), and save yourself £2,471.

If percentages are more your thing, then doubling that minimum monthly payment to 5% (£130 in month one), and you will pay the same amount off in 114 months (over 9 years) and incur £1,046 in interest – a saving of £2,620 from paying 2.5% per month.  

Of course, the best thing to do is eliminate that credit card balance as quickly as possible. This is the polar opposite of what the credit card companies want you to do as it should be abundantly clear how much they make per individual (on average) from interest charges.

Behavioral Shortcomings

Some people I know with outstanding credit card debt mistakenly feel as though they are on top of the situation by removing their ability to continue spending, while making those minimum repayments…

“I’ve locked the card away in a drawer” … or…  “I’ve cut it up and I’m paying the minimum off each month”

Unbelievably, I also know people who have sufficient cash savings that could clear their credit card debt IMMEDIATELY but choose not to!

They try and rationalise and compartmentalise their debt from their hard-earned savings and fail to see the very obvious solution in front of them.

They fail to see that If you have £5,000 of credit card debt and £5,000 in cash savings you have essentially ZERO!

Even when asked the seemingly obvious question …

“how much is your cash earning you versus how much your card is charging you?”

they still appear reluctant to take action.

Thinking it another way. Clearing personal debt (particularly those that charge higher rates of interest), can often be the best investment decision you can make!

As the Federal Reserve said when addressing personal debt levels in the United States…

“Paying down debt offers the greatest rate of return, one that no other asset class can match”

Until next time!

Dan

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Hello and welcome to Pursue FIRE. My name is Dan and I am the owner and author of all content on this site. I am passionate about personal finance and look forward to engaging with you.
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