Did you know the average American household carries $6,358 in credit card debt?
If that doesn’t sound too alarming, consider this: A debt of $5,000 with an interest rate of 24.99% (which is the current rate of a typical Capital One or Citibank card), where only the minimum payment is made each month and no additional charges are made to the card, accumulates $4,823 in interest over five years. That means the cardholder would be paying nearly double the amount that was originally spent!
Why do most Americans carry so much credit card debt and find themselves stuck in the debt trap? Let’s take a deeper look at credit card usage, debt and interest rates so we can understand this phenomenon and ensure credit cards are used responsibly.
The minimum payment mindset
According to the National Bureau of Economic Research website, a third of credit card holders make just the minimum payment each month.
Here’s how most people get trapped in credit card debt: You use your card for a purchase you can’t afford or want to defer payment, and then you make only the minimum payment that month. Soon, you are in the habit of using your card to purchase things beyond your budget. Since you’re making only the minimum monthly payment, it won’t seem to matter much if your credit card balance gets a bit larger.
This is a quick illustration to show how your “small balance” of just a few thousand dollars can really mean paying more than double that amount over the years because of interest.
Also, when you’re trapped in this mindset, your balance barely budges. With a debt of $5,000 and a minimum monthly payment of $150 (at 3% of the total balance), you’ll only be paying $47.30 each month toward your principal. The rest goes toward your interest accrued.
Credit scores and prolonged debt
Prolonged credit card debt can have a detrimental effect on your credit score. Your credit score gives potential lenders and employers an idea of how financially responsible you are.
One of the crucial factors used in determining your credit score is your debt ratio, or the percentage of available credit that you’ve already spent.Typically, the more of your available credit you’re using, the lower your score will be. If you’ve fallen into the minimum payment trap, there’s a good chance you’re using most of your available credit and hurting your score.
Even worse is when your credit card company sees that you’re running low on available credit, and may offer to increase your line — or even do it automatically. If you agree to the upgrade, there’s nothing stopping you from racking up another huge bill, further decreasing your score.
Another important component of your credit score is the trajectory of your debt. If you’re barely making progress on your balance, you won’t score high in this area either.
A low credit score can prevent you from qualifying for a mortgage, auto loan or even an employment opportunity. If you do get approved for such loans with your less than stellar credit score, you’ll likely be saddled with a hefty interest rate, which significantly increases your monthly payments and the overall interest you’ll pay.
Is it really worth racking up that credit card bill?
Should I throw out all of my credit cards?
Hold onto your cards. You need to have some open and active cards for maintaining a healthy credit score; however, it’s important to you use your cards responsibly.
First, be careful to avoid the minimum payment trap. Live within your means and stay clear of mounting credit card debt. Before using your card, ask yourself if it’s worth paying double its price in interest and possibly harming your financial health.
Second, if you’re already carrying a large credit card balance, stop using that card and work on increasing the amount you pay off each month. Even a relatively small monthly increase can make a big difference in the total amount you ultimately pay toward your balance.
Third, to use your cards responsibly and keep your score high, it’s best to use your credit card for non-discretionary payments, like your monthly utility bills. This way, you’ll be keeping your accounts active without running the risk of overspending. Remember to pay your credit card bill on time to avoid paying interest.
Finally, take a long look at your current cards. What’s the interest rate on your cards? Chances are, you’ll have a much lower rate when you switch to a card at Hope Credit Union.
A HOPE Visa credit card gives the option of paying for purchases over time without the pitfalls you’ll find with other credit card providers: outrageous interest rates and lots of hidden or excessive fees.1
1 Credit cards are subject to personal credit approval and terms and conditions of the Credit Card Agreement.
