Friday, March 4, 2011

“Revolving” vs. “Fixed” Credit Card Payment Plans

Let’s assume you have a credit card with an “APR” of 19.8% and a balance of $3,000.00. That shouldn’t be too hard to imagine. However, the sad fact is that most people would probably wish that they only had $3,000.00 worth of credit card debt. Furthermore, credit card interest rates in the mid to upper 20’s that are rivaling 30 percent are not too uncommon these days. But, for this example, let’s just stick with the numbers I mentioned above.

I would like to make one more assumption – let’s also assume that no new debt is going to be added to your credit card’s current balance of $3,000.00 (at least not until after you have paid off your current debt). If you are unable to pay off the full amount at one time, you may want to consider your options by looking at and comparing a few different payment plans. Let’s look at the differences in the payment plans below:

Plan A: A minimum payment of 2.5% of the balance, or $15.00 (whichever is greater) is paid each month until the balance is zero.

By choosing Plan A, it would take 21 years to pay off the original $3,000.00 and the total interest paid during that time would be $5,100.00.

Plan B: A minimum payment of 2.0% of the balance, or $15.00 (whichever is greater) is paid each month until the balance is zero.

By choosing Plan B, it would take 39 years to pay off the original $3,000.00 and the total interest paid during that time would be $10,538.00! So, by lowering the minimum payment by just 0.5% it would cost you an extra 18 years and over $5,000.00 more in the way of interest.

Plan C: A fixed payment of 2.5% of the beginning balance of $3,000.00 (or $75.00 fixed) is paid each month until the balance is zero.

By choosing Plan C, it would take 5.5 years an only cost $1,944.00 extra in interest payments.

The Bottom Line

Plans A and B are what is called “Revolving” payment plans. Revolving payments amounts are always changing – when the balance on the card changes, the payment amount changes. It would be my recommendation that you do not ever get lulled into paying the minimum payment on a credit card bill. I know how enticing it is to pay the lower amount, and that is exactly what the credit card company wants you to do, however, “there is no free lunch” and you will definitely be paying dearly for your indiscretions in the end! I write many posts on the positive power of compound interest with many investing examples; however, a revolving payment plan is a great way to demonstrate compound interest’s negative power as well – negative for you, but positive for the credit card company!

When eliminating debt it is best to stay clear of revolving payment plans. Besides actually paying off the full amount of the debt, the next best option is to make fixed affordable payments similar to that described in Plan C. Of course, if you happen to have extra money to put towards your debt, by all means add that on top of your fixed payment, however, don’t get into the habit of lowering your fixed payment because you want the compound interest to work for you – not against you!

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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