As financial sins go, many Canadians would probably regard having a carryover credit card balance of $1,000 as a minor offence. After all, the average credit card debt in this country is hovering around four times as much these days, according to consumer credit reporting agency TransUnion. And that’s only a fraction of the $21,500 in non-mortgage debt that Canadians carry on average.
It turns out, though, that even a relatively “small” $1,000 credit card balance can burn a considerable hole in your pocket.
Consider an imaginary scenario in which a made-up Canadian, Joe Canuck, uses his credit card to make a $1,000 purchase – let’s say a new dryer – on Jan. 1, 2018. Joe then puts that credit card on ice and proceeds to make only minimum payments on that $1,000 balance until Dec. 31.
How much will he pay in interest charges over one year? And how long would it take him to pay off that debt in full if he stuck to paying the minimum?
We assume that Joe has a typical “basic” credit card with an annual interest rate of 19.99 per cent on purchases. As with many credit cards, his monthly minimum payment is three per cent of the outstanding balance.
“Credit cards typically do not charge interest on purchases that appear for the first time on your credit card statement, and the payment due date is generally at least 21 days from your statement date,” according to Hoyes.
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So let’s say Joe’s statement date is Jan. 12. His payment due date would be Feb. 2. If he paid his balance in full by then, he would get to, essentially, borrow $1,000 for over a month for zero interest, Hoyes notes.
However, in our example, when Feb. 2 rolls around, Joe makes only the minimum payment of $30, or three per cent of his $1,000 balance. He pays no interest on that because it’s the first month. But interest charges will soon catch up to him.
At the beginning of March, Joe’s minimum payment has now risen to around $45, a whopping $16 of which is interest.
Here’s how that works. Joe’s outstanding balance in March has dipped to $970, or $1,000 minus the $30 he paid in February. Three per cent of that is $29, but Joe now has to pay monthly interest equal to 1/12 of his annual interest rate of 19.99 per cent, which works out to around $16. His total minimum payment is considerably higher than in February but that only reduces his outstanding balance to around $941.
If Joe keeps this up until the end of the year, he will end up paying $141 in interest and will still owe $700 of his original balance.
If Joe were to continue to make only minimum payments, it would take him almost 11 years to pay for his appliance.
And here’s the worst part: He would pay a mind-boggling $990 in interest, nearly doubling the price of the dryer.
Joe’s example may seem a bit of a stretch. At some point, minimum payments would drop to just a few dollars. Even the most financially stretched of us would be able to pay off the balance and save years worth of interest charges. But what if that credit card debt was the more typical $4,000 that many of us seem to carry?
The point is that “you may be paying nearly $2,000 over many years for every $1,000 you borrow on credit cards,” Hoyes said.
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The key takeaway here is that “compound interest is great when it works in your favour, but it’s deadly when you are paying it,” Hoyes said. Compound interest is the magic that lets your money grow by itself when you’re saving. If Joe had saved up $1,000 on Jan. 1 with a monthly interest rate of one per cent, he’d earn $10 in the first month. During the second month, he’d get another one per cent not just on $1,000 but on $1,010, and so on.
When you’re carrying a credit card balance, though, you’re on the receiving end of compound interest. If you only make minimum payments, what you actually pay the credit card company can end up being far higher than the number you see on your credit card balance.
And if you get to the point where all you can afford to pay is the minimum payment, paying off that debt becomes very tough. You may need to renegotiate your debt load through a debt management program or consumer proposal to dig yourself out of the financial snowball that is compound interest when it comes to credit cards.
“With a consumer proposal, the average you pay is about a third of your debt, so it is very common for us to negotiate a consumer proposal where you pay $300 for every $1,000 in debt, so it’s a great way to get out of debt for an affordable cost,” said Hoyes.
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The beating you can get from compound interest is greater the higher the interest is on your credit card. That’s why it’s important to be aware of the interest charges associated with each of your cards, especially if you have many, said Hoyes. When you’re repaying debt, prioritizing the balance with the higher interest is a good idea.
Carrying a credit card balance doesn’t necessarily damage your credit score if you keep making minimum payments on time. But that’s not the end of the story, according to Hoyes: “Your credit score is based on a number of factors, but one of them is utilization, or what percentage of your total borrowing limit you are actually borrowing.”
Though consumer credit reporting agencies are tight-lipped about the exact formula behind credit scores, Hoyes advises keeping your utilization rate below 20 per cent to avoid a downgrade.
Credit card interest rates don’t seem to move in lockstep with other interest rates in Canada, according to Hoyes. So the fact that things like mortgage rates are climbing doesn’t mean your credit card rate will follow. Still, if your mortgage payment goes up, that will leave less money in your pocket to throw at your credit card debt.
TransUnion has predicted a rise in credit card delinquencies this year as higher rates on other loans force more Canadians to miss minimum payments.
Now for the good news: Boosting your credit card payments by even a few dollars over the minimum works miracles. According to the credit card payment calculator of the Financial Consumer Agency of Canada, if Joe had bumped up his monthly repayments by just $5, for example, he would have saved nearly $380 in interest and been able to pay off his balance almost four and a half years earlier.
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