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A minimum payment is just an interest payment
For example, if you have $2,000 in credit card debt, at a 26% interest rate, and a minimum monthly payment of $45. It will take you almost 13 years and cost you an additional $4,900 in interest to pay down your debt.
With each payment, you’ll be contributing $1.67 to the principal, this is against your actual debt, and $43.33 to interest. That’s right, only 4% of your payment goes toward paying down the original amount.
What is the debt cycle?
The most common reason for being in this position in the first place is a lack of an emergency fund when an unplanned life event arises.
Unfortunately, over 13 years, the chances of another unplanned life event happening, is extremely high. And again, without an emergency fund, a cycle develops.
The debt cycle will put an end to your savings dreams before they begin. But there is hope!
Break the debt cycle
Here are a few simple steps to help you break the debt cycle:
1. Keep paying the minimum amount
Isn’t this a bad idea? Generally, yes.
In this case, however, you’ll be breaking the debt cycle. To do this, you need to build a small emergency fund to insulate you from the next unplanned life event.
While you do that, you do not want to default on your credit cards, hence the minimum payment.
2. Build a small emergency fund
Unfortunately, there isn’t a magic amount you should save. You know your situation best. If you’re expecting car troubles or the like, try to anticipate. Otherwise, if it’s an arbitrary amount, start with one paycheck’s worth.
3. Pay down your debt!
Now that you’ve created some buffer with your emergency fund, it’s time to focus on the real problem, your debt!
In the example above, if you were to double your minimum payment to $90, it would reduce the payoff time from almost 13 years to 2.6 years. You’d still be paying the same $43.33 in interest, but every additional dollar would go toward the principal balance.
Pick a time-frame you’re comfortable with, but don’t drag it out too long. See those interest payments as just more time spent grinding at work, not contributing to your savings.
Build your emergency fund
Luckily, this method can work with any kind of debt, not just credit cards. There are many calculators out there, like this one, that can help you get more specific with your situation.
Once you’ve broken the debt cycle, you should keep building your emergency fund. Try saving six months’ worth of living expenses for optimum peace of mind.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.