Find out how interest on credit cards is calculated and how to make smart payment choices to improve your financial situation.
Amortization is just a way of saying that a debt is being paid off over a period of time. The big impact comes from the how the debt is paid off, fast or slow, and how high the interest rate is. Careful choices can help erase a debt in a much shorter time and cost a lot less in the process.
Amortization With Simple Interest
The big difference between a mortgage and a credit card debt is the way the interest is calculated. A mortgage payoff is calculated using simple interest, meaning that the interest is charged only on the principal balance due. As an example, if you owe $50,000 with an interest rate of 5% and your mortgage payment is $395.40 per month for fifteen years, your first payment is applied $208.33 to interest ($50,000 times 5% annual interest divided by 12 months) and $187.07 to principal ($395.40 minus $208.33).
When you make the second payment, your principal balance is now $49,812.93 ($50,000 minus $187.07), so your second payment is applied $207.55 to interest ($49,812.93 times 5% annual interest divided by 12 months) and $187.85 to principal ($395.40 minus $207.55). Each month as you make your payment, the principal balance goes down slightly and more of your payment applies to the principal until eventually the principal balance reaches zero.
Credit Card Amortization Including Compound Interest
When you have a credit card debt, the interest is compounded, meaning it is calculated on the total amount due, including any interest charges that have been added in prior months. If you carry the debt for a long time, you end up paying interest on interest on interest, which can add up to big numbers.
Take an example of a credit card balance of $2,000 on a card with an interest rate of 10%. A typical minimum payment on a credit card is 4% of the balance, which would mean a payment of approximately $80 per month. At the end of the first month, your interest is calculated as $16.67 ($2,000 times 10% annual interest divided by 12 months). Add the $16.67 interest to the beginning amount due of $2,000 for a total of $2,016.67. Your credit card statement will show a minimum payment due of $80.67 (4% of $2,016.67). If you make that minimum payment, your next statement will show a balance due of $1,936 ($2,016.67 minus $80.67) and the interest will be $16.13 ($1,936 times 10% annual interest divided by 12 months).
After 1 year, you will have paid $168.30 in interest, $814.56 in total payments (maintaining only the minimum 4% payment, which decreases each month as the balance decreases) and have a balance of $1,353.74. You will have paid $6.93 more interest than if your payment was calculated using simple interest. While this doesn’t sound like much, look at the numbers with using some other examples.
If you just continue making an $80 per month payment for 1 year, you will have paid $164.18 in interest and have a balance of $1204.18. Keep this up for slightly more than 2 years, and your balance will be paid off, with total interest charges of $251.98. If you had continued to pay the minimum payment, even if you didn’t let that go below $25 per month, you would pay $436.81 in interest charges and it would take more than 5 years to pay it off.
Double the debt and the numbers are even more surprising. A debt of $4,000 paid at the minimum payment without letting the payment amount drop below $25 still takes almost 7 years to pay and almost $1,000 in interest charges. Make a payment of $160 consistently and the debt is paid off in just over 2 years with interest of $500. Make a payment of $200 per month consistently and the debt is paid off in less than 2 years with less than $400 interest.
Make Credit Card Payment Choices That Benefit You
Banks don’t care if you drag out your minimum payments until the bitter end. As long as there is a balance due carried over, they are making money. If you choose to make the highest possible payments that fit your budget, you’re making the choice that is best for your finances. Go to bankrate.com for a useful credit card amortization calculator
Sometimes purchases can’t be delayed and it’s helpful to have the option to use a credit card when it’s needed, but when you understand credit card amortization, you can make smart decisions about how to pay off the outstanding balance.
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