To better understand why paying the minimum can be so costly it is important to learn how the minimum payment is calculated. For an example let’s take a look at a credit card with a balance of $1,000 that has an APR of 18%. When you break the APR down to twelve monthly periods you end up with a 1.5% finance charge per month. For this example we will also use the assumption that the card calculates the minimum payment by 2.5% of the balance.
This means your minimum payment in the first month is $25, or $1,000 x 2.5%. With the card’s APR of 18% or 1.5% per month that means of that $25 payment only $10 is being applied to the balance while the other $15 is paying that month’s finance charge. During the next month your remaining balance is now $990 so your next minimum payment would be calculated as $24.75 ($990 x 2.5%). For this payment $14.85 covers that month’s finance charge while $9.90 is applied to the balance.
As you can see above, you have made almost $50 in payments yet only reduced your balance by $19.90. If you were to continue paying only the minimum and the features of this card remained unchanged it would take 153 months or almost 13 years to pay off a $1,000 initial balance. This would result in paying $1,115.41 on just interest alone, more than the amount of the original balance!