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By Russell Cavanagh
Staff Writer, 21 August 2008
"HOW much am I required to pay back on my credit card?" will be asked by anyone examining their household budget as money tightens over the coming months, possibly years, of the credit crunch.
If a credit card account can't be settled before the end of the month the option to repay monthly is of course built in. This is how credit card companies make a profit.
How much you are actually "required to pay" depends on: how little you want to get away with paying; how much you need to pay to make sure the final balance doesn't reach astronomical proportions because of gathering interest; and how much is required each month to reduce the overall period of repayments.
But are the answers always the same?
Minimum monthly payments option
When signing a credit card agreement, the company sets an absolute minimum amount it expects to receive back each month. Minimum payments vary.
Most credit card companies expect a minimum repayment of £5 per month or around 2% to 3% of the outstanding balance - whichever is greater in value. With cards designed for people with poor credit ratings, such figures may be increased to as much as £25 or 5% (again, whichever is greater).
Falling below that contractual minimum repayment can mean default charges added to your account and the remaining debt growing at an alarming rate as well as even having your card withdrawn. It can also result in a default being entered on your credit reference file and your ability to get further credit being impaired as a result.
Knowing you can meet minimum payments in periods of financial difficulty is reassuring. However, it's important to be aware of the wider implications on your wallet or purse.
Why avoid minimum payments?
Keeping to the minimum payment has its drawbacks. You will pay more interest and therefore extra money over a longer time before settling the account.
Here are a couple of examples based on borrowings pegged at the current average credit card interest rate of 16.9% per annum:
If you owe £2,500 and pay minimum repayments set at, perhaps, £80 per month (3.2% of balance), you would end up paying interest totalling £737. It would also take 41 months - nearly three and a half years - to pay off the balance. However, paying £185 a month would generate interest totalling only £270 - a saving of £467. It would also take just 15 months to repay in full.
Given that minimum repayments are set at a percentage of the amount outstanding, a higher balance would invoke higher minimum payment rates. So, if you owed £5,000 on your credit card, the minimum repayment may be rounded to £155 (3.1% of total balance) and it would take 43 months to pay with interest amounting to £1,541. But if you repaid £370 a month, interest would total £539 (saving £1,002!) and the term would reduce to 15 months.
Calculate your minimum repayment by dividing your outstanding balance by 100 then multiply it by the percentage figure your card company says is the minimum payment. This will give you the figure in pounds. Do remember though that there may be a minimum cash figure payable and this would likely kick in if you have worked out your minimum repayment on a small balance owing.
It makes sense to pay as much as you can once other priorities in your household budget are suitably accounted for.
How do repayments settle the balance?
Credit card companies exist by making money out of lending. Good news is that most credit cards nowadays charge interest on a daily basis. This works out significantly cheaper than interest applied weekly or monthly.
However, they still allocate repayments in such a way as to reduce the cheaper debts - those attracting the lowest interest rates - on your card first, leaving the more expensive ones until last in the hope of gathering further interest.
Cheaper debts typically include balance transfers or purchase repayment periods set at 0%. Fees and interest on other purchases or cash withdrawals are almost certainly the most expensive items and so will be credited last. Otherwise, transactions will usually be paid off in the order they were added to the card account.
A useful way of dealing with this problem is by transferring your balance to a card offering a 0% interest period on balance transfers and spreading repayments. This is particularly true of larger balances.
Capital One, Virgin and Tesco are just some providers who offer credit cards with initial 0% interest deals on balance transfers.
Other considerations to weigh up
Cash withdrawals on credit cards are never recommended. Usually, such transactions carry a separate, often higher, rate of interest applicable from the date of the withdrawal.
Remember too that there are often transaction fees that apply and cash transactions will never be covered by any 0% period.
To sum up
Credit cards offer convenience and flexibility. Used wisely, they can provide reasonably cheap credit as well as give opportunities to transfer problem balances from other credit cards.
It is a mistake though to see credit cards as a way of purchasing goods or services with minimum repayments in mind from the start. Making minimum repayments can be needlessly costly and should only be used where your budget has become tight and there really are no alternatives.
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