Credit Card Debt
You probably already know what a credit card is and what it does, but let’s just start with the basics of credit card debt and work our way up.
Lines of credit are considered loans, and they allow you to buy things without having the money up front; the credit lender provides the money for your purchase, and you use that money by swiping your card at the register. You’ll pay that money back over a period of time, not to the business from whom you made your purchase, but to the lender whose credit card (and money) you used -- and you’ll be paying back the amount of money you’ve already used, along with interest rates and other additional fees.
Credit cards are considered to be high-risk loans, meaning that the lender has neither collateral from the debtor nor a guarantee that the debt will be repaid on time. Because of this, credit card companies charge high interest rates every month, which are added to the initial amount owed, to ensure that they’ll be repaid the entire amount that was originally lent out.
Things can get a little confusing with credit card debts, because these lines of credit are considered open-ended. This means that, as long as the debtor possesses the credit card and makes minimum payments toward the debt each month, he or she is able to keep using the lender’s money and increasing the amount of debt owed. That part is simple enough, but the confusing part is that the amount of interest doesn’t necessarily stay the same; it changes according to the amount of money still owed and according to how timely the debtor’s payments are. Simply put, credit card debt can become overwhelming and seemingly unmanageable in the blink of an eye because interest fees change and increase so quickly.
Understanding Credit Card Interest Rates
So let’s try to untangle the confusion that is the credit card interest rate. First of all, it’s important to understand that credit card companies require debtors to make a minimum payment each month, and all too often, people are led to believe that simply making this minimum payment on time is enough to pay back their debt quickly and efficiently.
But here’s the catch: It’s not.
The minimum payment usually only covers the monthly interest rate and a small percentage (about 1-2%) of your actual balance owed. Interest rates tend to be around 17-20% of the current balance owed, allowing it to seem like you’re making a dent in your original balance, when you’re really only paying a very small portion of it. Minimum payments become even more complicated if you consistently use the card to make more purchases, i.e., you increase your original debt. As your base balance increases, your minimum payments will start to increase as well, since the interest rates on credit cards are percentages rather than flat rates.
Let’s take a look at two examples of credit card debtors:
Debtor A has $2,000 in credit card debt and the credit company charges a 20% interest rate to be paid each month, in addition to a minimum payment of 3% of the debt balance. Debtor A’s monthly interest rate costs come to $33.33, and the total minimum payment is $60.
Debtor B is in the exact same situation: same balance, same interest rate, and same minimum payment.
Debtor A pays the minimum $60 each month, but Debtor B pays $10 more and sends in a $70 payment each month. After this first payment, Debtor A still has $1,973.33 left from the original balance, while Debtor B has $1,963.33 left. There’s only a $10 difference in the remaining amount of debt, and that doesn’t seem like a big difference, right?
But if the two debtors continue to make the same payments respectively, it will take Debtor A 15 years
to pay off a debt of $2,000. Debtor B, on the other hand, will be debt-free in 7 years.
Just by paying an extra $10 per month, Debtor B is able to pay off the original debt in less than half the time it takes Debtor A.
In conclusion, it’s often not enough to just make the minimum payments each month. Credit card companies take advantage of complicated policies (like with interest rates) and they take advantage of the confusion of their debtors.