This week I’d like to talk about Credit Cards. I know, I know, it’s not a comfortable subject. But it’s got to be tackled sooner or later. Because borrowing on a Credit Card just doesn’t fit with my philosophy of Easy Money Management.
Yes, I agree that they can be useful in an emergency, as an alternative kind of “rainy day fund”. But persistent credit card borrowing is very bad for your financial wellbeing. If you pay your credit card off every month, then I congratulate you. But if you are borrowing on your credit card and repaying only the minimum amount each month, then you need to read on.
Let me use an analogy to explain. Using a credit card is a bit like going to the beach.
- Some people never go to the beach, but most of us do. Likewise, some people don’t have a credit card, but more than half of all adults do.
- At the beach, a lot of us don’t go swimming. At most we have a quick paddle, or we splash around at the water’s edge, but we never get out of our depth. Similarly, most credit card holders never pay interest – either they don’t use their card at all or they pay off the entire balance every month.
- And some of us go in deeper for a proper swim. About a third of all credit card holders only pay the minimum amount every month. This is like going in for a swim, and never coming out of the water.
The Financial Conduct Authority (FCA) regulates the Credit Card business. They published a big study about a year ago that’s full of interesting revelations. They analysed actual credit card repayments in 2014 and discovered that:
- About 30% paid off the whole balance
- About 40% paid only the minimum payment – or less
- The remaining 30% paid somewhere between the whole balance and the minimum payment; most of these payments were either for just over the minimum or for just less than the full amount as the following chart shows.
This strange-looking chart is worth studying. Notice how all the payments are bunched up at either end of the chart, with almost none in the middle. It’s clear from the chart that credit card users fall into two very different groups:
- Most cardholders are “Paddlers” who don’t leave a balance on their account – if they use the card they pay off the balance at the end of the month, or within a few months.
- A significant minority of cardholders are “Swimmers” who have a persistent balance that never gets cleared and typically pay only the minimum payment each month.
The chart shows that there are no “average” or “moderate” credit card holders – we’re all either Paddlers or Swimmers. Which are you – a Paddler or a Swimmer?
Why do so many pay only the minimum?
Of course you can pay any amount you choose. But just including a minimum payment number on their statement makes the customer more likely to decide to pay that amount, rather than a larger amount. Psychologists call this “anchoring”. It’s like the opening bid or offer in a negotiated transaction – the opening number “anchors” the rest of the negotiation.
In fact the FCA found that almost a third of credit cards (31%) are repaid by a monthly Direct Debit that is automatically set to the contractual minimum – these cardholders are permanently “anchored” to the minimum payment.
Buy once but pay twice
The average interest rate on credit cards is about 18%, which much higher than for overdrafts (10%) or personal loans (7%). As a result, users who pay only the minimum repayment each month, typically end up paying for everything at least twice. Does that seem incredible? Let me demonstrate.
Minimum monthly repayments vary, but “1% of the balance plus interest” is quite common. On a balance of £4,000 the minimum repayment will typically be about £100:
– £40 of principal repayment (1% of £4,000), plus
– £60 of interest payments (18% per annum = approx. 1.5% per month x £4,000)
So for every £10 you repay, less than half goes to pay for things you bought, and all the rest goes to swell the profits of the Credit Card company.
Don’t pay the minimum amount
The FCA report recognized the “anchoring” effect of the minimum payment amount that appears prominently on your monthly statement. Paying such a low amount every month means that the debt never gets repaid – just endlessly rolled over.
The FCA is now in talks with the industry about how this anchoring effect can be removed. Not surprisingly, the big banks are dragging their feet. Big fat turkeys don’t vote for Christmas.
Ideally your monthly statement should say something like this:
“If you are very hard up this month then it’s OK to pay the minimum. But please don’t make a habit of it.”
Here’s a useful rule of thumb – if you can afford to pay off 10% of the balance on your card, then you can pay the whole thing off, including interest, within a year. But only if you pay the same fixed amount every month. Whatever you can afford to pay, why not pay that by standing order, so it goes out of your Bills account every month, just like a personal loan repayment. The payment will go out automatically, so you won’t be tempted to pay only the minimum payment amount that appears on your statement.
So forget about the minimum payment – cut yourself free from the anchor and swim for the shore.