Since credit allows us to stretch out the cost of an item with payments over a period of time, this makes purchases on credit seem more affordable. Maybe I can’t afford $650.00 today, but I think that I can afford $65.00 a month for ten months, and so I buy the item using credit. I figure that ten months isn’t that long, I can have what I want today, and I’ll pay off the balance as soon as I can so that I won’t be paying a lot of interest charges.
There are a few things wrong with my thinking. First, a lot can happen in ten months that I might not be prepared for like an unexpected car repair or an appliance needing replacement. Second, I’ll still be using the credit card for other purchases that I normally make, and third I probably won’t be able to pay off the balance as quickly as I hope. In addition, it’s really not simply a $65.00 payment for ten months. There is always a price when we borrow (use someone else’s money), except on those rare occasions when we can borrow at zero percent interest.
There are three variables at work with paying over time: the loan amount, the term (length) of the loan, and the interest rate. Changing any of these will change the total amount that we pay. With credit cards, the duration or term of the loan is determined by our balance and our payment habits. We’re not borrowing for a specific length of time with credit cards like a car or a personal loan. If we pay the balance in full, then the term of the loan is zero months, and there is no interest paid. If we pay the minimum, then the term can stretch on for many years.
The table below shows the effect that payment habits have on a credit card balance of $650.00 with an interest rate of 15%, using different monthly payment amounts.
Changing the monthly payment changes how long it will take to pay off the balance (term in months) and the total interest that will be paid. Credit card companies now include on their monthly statements the length of time that it would take to pay off the balance and the total amount paid if we choose to make the minimum payment. In the table above, the first row shows the results of making the minimum payment, and the example assumes that this credit card is not being used to make purchases. The balance is reduced as a result of the payment and the interest charged. When we continue to use a card that already has a balance, the balance and the interest charged are impacted by our monthly charges, and the duration and interest we’ll be paying increase.
Consider if we only made the minimum payment of $31.52 and typically charged another $100.00 each month to this card. Since the payment that we’re making is less than the amount we’re charging each month, we know where this is headed.
We would be paying $31.52 each month, but the payment would only lower the balance by just $23.39 (the payment of $31.52 minus the interest charge of $8.13), and the balance would increase as a result of the $100.00 in additional purchases. As shown below, this is a recipe for problems since the balance just keeps growing.
There are practical reasons for using a credit card, but before making a purchase using credit we should always ask ourselves if we really want to borrow the money. If we don’t pay the entire balance when the monthly payment is due, that’s exactly what we’re doing. In many cases, waiting and saving for the purchase is a wise choice.