Did you know the average American household carries $6,358 in credit card debt?
If that doesn’t sound too alarming, consider this: A debt of $5,000 with an interest rate of 24.99% (which is the current rate of a typical Capital One or Citibank card), where only the minimum payment is made each month and no additional charges are made to the card, accumulates $4,823 in interest over five years. That means the cardholder would be paying nearly double the amount that was originally spent!
Why do most Americans carry so much credit card debt and find themselves stuck in the debt trap? Let’s take a deeper look at credit card usage, debt and interest rates so we can understand this phenomenon and ensure credit cards are used responsibly.
The minimum payment mindset
According to the National Bureau of Economic Research website, a third of credit card holders make just the minimum payment each month.
Here’s how it usually happens: You use your card for a purchase you can’t really afford, or you want to defer paying for it from your savings. When your credit card bill arrives, you either choose to make just the minimum payment or it is all you can afford to pay at the time. You figure you’ll pay off the rest when your finances improve. Soon, you’re in the trap of pulling out your card whenever you want to purchase something beyond your budget. Since you’re only making the minimum payment, it seems like it doesn’t matter all that much if your credit card debt grows a little larger. From there, the cycle continues as debt climbs and you continue using your card for purchases you’d be better off not making.
This is a quick illustration to show how your “small balance” of just a few thousand dollars can really mean paying more than double that amount over the years because of interest.
Also, when you’re trapped in this mindset, your balance barely budges. With a debt of $5,000 and a minimum monthly payment of $150 (at 3% of the total balance), you’ll only be paying $47.30 each month toward your principal. The rest goes toward your interest accrued.
Take a moment to think about this the next time you decide to use your credit card to pay for something you can’t afford. Is it worth paying $5,000 over the next five years for a $2,500 vacation?
Credit scores and prolonged debt
Another important aspect of prolonged credit card debt is the detrimental effect it can have on your credit score. Your credit score gives potential lenders and employers an idea of how financially responsible you are.
One of the crucial factors used in determining your credit score is your debt ratio, or the percentage of available credit that you’ve already spent. In most credit score formulas, the more credit you’ve used, the lower your score. If you’ve fallen into the habit of using your credit card whenever you’re short on cash, and are only making the minimum payment each month, you likely use a high percentage of your available credit.
Even worse is when your credit card company sees that you’re running low on available credit, and may offer to increase your line — or even do it automatically. If you agree to the upgrade, there’s nothing stopping you from racking up another huge bill, further decreasing your score.
Another important component of your credit score is the trajectory of your debt. If you’re barely making progress on your balance, you won’t score high in this area either.
A low credit score can prevent you from qualifying for a mortgage, auto loan or even an employment opportunity. If you do get approved for such loans with your less than stellar credit score, you’ll likely be saddled with a hefty interest rate, which significantly increases your monthly payments and the overall interest you’ll pay.
Is it really worth racking up that credit card bill?
Should I throw out all of my credit cards?
Hold onto your cards. You need to have some open and active cards for maintaining a healthy credit score; however, it’s important to you use your cards responsibly.
First, be careful not to fall prey to the minimum payment mindset. Live within your means and learn to find happiness in what you have instead of chasing the elusive and transient thrill of material possessions. Before using your card for something you can’t afford, imagine this purchase haunting you for years to come. Is it worth paying double the amount it costs in interest payments? Is it worth harming your financial health?
Second, if you’re already carrying a large credit card balance, stop using that card and work on increasing the amount you pay off each month. Even a relatively small monthly increase can make a big difference in the total amount you ultimately pay toward your balance.
Third, to use your cards responsibly and keep your score high, it’s best to use your credit card for non-discretionary payments, like your monthly utility bills. This way, you’ll be keeping your accounts active without running the risk of overspending. Remember to pay your credit card bill on time to avoid paying interest.