Minimum Payment = Maximum Payoff Time

Want to be your credit card company’s favorite customer? Just max out your card’s limit, agree to pay interest at a rate of 18% to 25%, and make only the minimum payment each month.

The minimum monthly payment is set by each card issuer, but it’s typically about 2% of the outstanding balance. Card companies want you to pay only the minimum, so that most of your payment is interest, not principal.

While you might be tempted to make only the minimum payment, that could be one of the most expensive decisions you ever make. Let’s see how three strategies affect the total cost, assuming the card has a balance of $5,000 and no further purchases are made:

*The minimum is assumed to be 2% of the outstanding balance. The payment starts at $100 a month and gradually declines: The first $75 is interest; only $25 is applied against principal. Thus, in month 2, the new balance is $4,975 — so the new minimum is $99.50 (two percent of $4,975).

As you can see, making the minimum payment is expensive. That’s ironic, because people choose the minimum payment precisely because they think doing so saves them money (which it does — but only in terms of monthly cash outlay). That’s why you must always pay more than the monthly minimum. How much more? Ideally, you’ll pay off the entire balance!

Named #1 on Barron’s 2009 List of Top 100 Independent Financial Advisors, Ric Edelman is chairman and CEO of Edelman Financial Services, the host of “The Ric Edelman Show,” and the best-selling author of seven books on personal finance. His firm manages billions of dollars for consumers nationwide. Visit RicEdelman.com to learn more.

Ric is President and Director of Sanders Morris Harris Group. Ric is an Investment Advisor Representative and offers advisory services through EFS an SEC-registered investment advisor. He is also a Registered Representative of and offers securities through Sanders Morris Harris Inc., an independent broker/dealer, member FINRA/SIPC.