The Minimum Payment Trap
Want to get out of debt in the most expensive, most lengthy way possible?
Here's a radical suggestion. Don't even look at the minimum payment on your credit card bill. Why not? Because although it gives you a glimpse at the least possible money you can get away with sending to the card company this month, that's the worst thing you can do for your financial future.
And looking at the minimum is an akin to seeing a suggestion that's the amount you should pay. This is due to a little-known psychological trick called, the anchoring effect.
How Long Is The Mississippi River?
The anchoring effect occurs when unrelated data influence your opinions or decisions. Here's an example. Two groups of people were first asked whether the length of the Mississippi River was greater than or less than an arbitrary distance (the first group was shown 70 miles while the second group was shown 2000 miles). They were then asked for their estimate of the river's length. Not surprisingly, the second group picked a much higher estimate for the length of the Mississippi. Both groups had been anchored by the initial data point, even if it wasn't realistic.
Do you want to pay four times as much interest?
A customer's credit card payment behavior is influenced in the same way. A study by Neil Stewart at the University of Warwick tested how card borrowers who don’t usually pay balances in full respond when shown a statement with minimum payment, compared to those given a statement where the minimum payment is omitted. The results were amazing. Borrowers who weren't shown a minimum payment actually paid 70% more than those shown a minimum. Given average interest rates, Stewart found this effect will get credit borrowers to pay four times more in interest over the life of their debt.
Minimums aren't there for you.
Credit card companies clearly know this. In an NPR special, Andrew Kahr details how he helped change credit card practices to reduce minimum payments from 5% to 2% to lengthen the repayment period for borrowers and increase profits.
So what should you do? First, recognize that your credit card company is not suggesting a minimum payment to be nice, they're hoping you take longer to pay off your debt. Second, don't base your decisions on the minimum payment—commit yourself to paying a constant amount above the minimum and stay with that amount over time regardless of the statement minimum.
By being aware of how you respond to the banks' strategies, you're better equipped to get yourself out of debt.
Article was written by Jean Chatzky originally for SavveyMoney®.