Behold, the credit card payment. Pretty much the only debt payment in your life that will change each month, leaving many mystified as to how it is calculated, and what happens to your principal each month, which is the amount you still owe separate from interest.
I can shed a little light on this for you, but I must warn you that it’s going to get a little math-y up in here–but not too bad! I promise.
Let’s use this example:
$1,200 outstanding balance
15% interest rate (fixed!)
Payment calculated as 2% of outstanding balance*
Step 1 To calculate your minimum payment, multiply your outstanding balance by your payment calculation factor. In this case: $1,200 x 2%= $24
Step 2 To determine what portion of this is applied to interest, multiple your outstanding balance by your interest rate ($1,200 x 15% = $180). This is the amount of interest you would pay over 12 months, if these factors remained true for all 12 months. (Which they won’t, because you make payments each month.)
"So promise me, PROMISE ME, you will ALWAYS make MORE than the MINIMUM PAYMENT."
You then divide that number, $180, by 12, to determine the portion of interest you will pay this month: $180 / 12 = $15.
Step 3 Subtract your interest payment (step 2) from your minimum payment (step 1) to determine how much ends up being applied to your principle (outstanding balance). $24 - $15 = $9.
Step 4 So promise me, PROMISE ME, you will ALWAYS make MORE than the MINIMUM PAYMENT. Seriously!!
If you are only applying $9/month to your outstanding balance of $1,200, it’s really no wonder why credit card companies get rich and you and I get stuck in debt. They are making $15 off this scenario, and your debt is only decreasing by $9. That’s like…one Happy Meal.
Any extra money you put towards your payment will be applied directly to your principle balance. There is no magic number here, necessarily, but I always advise paying as much as you can.
The interest you will pay in this example if you only made your minimum payments? $1,184.53, over the next 141 months. What if you made $50 payments each month? You will only pay $235 in interest and have it paid off in 29 months. Quite the savings, eh?
*Read your disclosures to determine how your credit card provider calculates your minimum payment. Yes, you actually should read those things.
Photo credit iStock