What happens when you make the minimum payment on your credit card? Why do so many credit cardholders find themselves caught in a debt spiral? And why does it take months to repay even the smallest outstanding balance on your card? While exorbitant interest rates are the primary culprit, it’s the wrong approach towards credit card payments that will land you into serious financial trouble.
If you have ever been tempted to pay the bare minimum on your credit card, you will know it can bring temporary relief because you feel you have at least met your financial obligations. But do this on a continuous basis and you will eventually discover it is one of the worst financial mistakes you can make.
Here’s an example to help you understand why. Let’s say you just received your credit card statement, and are weighing your repayment options based on the following information:
• The outstanding credit card balance is Dh10,000
• The annual percentage rate (APR) is 40 per cent (calculated based on an interest rate of 2.9 per cent per month)
• The minimum monthly payment required by the card provider is 5 per cent or Dh100, whichever is higher
Now look at the box below and you will see five different ways to pay off this credit card balance. Under each option, we calculated how long it would take you to pay off your credit card debt and how much you would have to shell out in interest payments during that period. Study the figures and then read each scenario carefully:
Scenario 1: Let's just start by saying this is the worst option of all. By making the minimum five per cent payment every month, you will take more than a decade to repay the debt, and will end up paying 2.7 times more than the original credit card balance of Dh10,000.
This scenario specifically goes to show what a big difference paying just Dh100 above the minimum payment can make. It cuts down the repayment period and interest payments by more than half, when compared with the first scenario.
Scenarios 3 and 4: The sooner you can repay the debt, the lesser the damage in terms of interest payments. Quite simply, a fixed monthly payment of Dh5,000 is better than Dh1,000. What's more, paying off a higher portion of your credit card debt every month will lower your Debt Burden Ratio (DBR) and improve your credit score too.
Scenario 5: This is the best, and without a doubt, the right way to repay your outstanding balance – wiping the slate clean by the payment due date.
So, what’s the ideal solution?
Most credit card providers offer a grace period of between 21 to 26 days once the monthly credit card statement is generated. You can repay your credit card bill in full before the grace period expires to avoid paying interest.
If you need to take the debt route, apply for a personal loan, preferably the salary-transfer variant. Based on our recent analysis, the average interest/profit rate for salary-transfer personal loans is 6.5 per cent per annum. For non-salary transfer personal loans, the average rate was 13 per cent per annum.
When compared with the average annual rate (APR) being charged on credit cards in the UAE, which is an enormous 40 per cent, the decision to avoid racking up credit card debt altogether seems like the most sound one.
But what if you’re already stuck with credit card debt? Then you must focus on budgeting and cutting the extra expenses, so you can save more and use that money towards paying off all your dues. Given the high interest rates on credit cards, it may even make sense to liquidate other investments and assets to pay off the debt and improve your net financial position.
Ambareen Musa is the founder and chief executive of Souqalmal.com.
Follow us on Twitter @TheNationalPF