The following is a guest by Tim Chen, founder and CEO ofÂ NerdWallet.com. NerdWallet that helps consumers to compare credit card rewards.Â Tim also educates consumers about credit cards and debt management at the Forbes Moneybuilder Blog, the Huffington Post, and U.S.News.
Payment protection insurance can sound great when it’s being pitched by a commissioned credit card salesman. Depending on the credit card company, you’ll typically pay a fee equal to something like 1% of your credit card’s outstanding debt each month (in addition, of course, to your minimum payments). In exchange, your payment obligation will be waived for a set amount of time if you become sick, unemployed, or otherwise unable to make your payments. While terms vary by card issuer, you could get 24 months of waived minimum payments for job loss or debilitating injuries.
I mean, 1% sounds tiny in the greater scheme of things, and in exchange you never have to worry about getting charged a huge late payment fee.
Question the benefits
There are a few things that you should consider before you sign onto a payment protection insurance plan, though. For one, you should consider the nature of the debt you’re insuring. It’s unsecured. In contrast to mortgages, car payments and other forms of secured debt that have a physical asset as collateral, credit card debt has nothing to back it up except your ability to make payments.
If someone goes bankrupt, the secured creditors are the first in line to be paid back. Once they’ve been paid in full, unsecured creditors can be paid ““ if there’s anything left to pay them with.
Due to the nature of the debt people owe them, credit card companies have a tendency towards flexibility. If you’ve made consistent payments for years, then lose your job, your credit card provider will probably cut you a break, offering an amnesty from payments for at least a couple months.
They do this because it’s in their interests as much as it is in yours. Sacrificing a couple monthly payments now saves them from having to write off your entire balance in the future.
Weigh the costs
The price of payment protection also bears mentioning. It’s roughly 1 percent, which doesn’t sound like much. However, that’s 1 percent per month, or roughly 12 percent per year if your balance stays constant. Unless you have a low interest credit card, you probably have a 15 percent interest rate already, your payment protection insurance is going to raise your effective interest rate closer to a far-more-substantial 28 percent.
This is clearer when you put it in dollar terms. Say you owe $1,000 on your credit card. A typical credit card company might require a 2 percent minimum payment every month, or $20. Payment protection, though, adds another $10 to each payment. What was $20 is now $30. Over five years, you’ll end up paying something like an extra $600.Â More if you add to your balance over that time, but less if you manage to pay some or all of that debt off (as you should).
And the thing is, this $600 is not going towards your credit card’s principal. It’s just like auto or health insurance, in that you only get any benefit from it in emergency situations.Â And unlike health insurance, if you end up using payment protection and passing on a few payments, your credit card company will most likely charge you interest on the payment protection fees as well. It should be noted that while your payments may be waived for a few months, your debt is still intact and you will continue to accrue interest on your balance while you’re not making payments, which will end up putting you in an even worse situation than before.
So think twice about payment protection. Think about where else that money could go. It could go into an emergency savings account that can be used for any expenses and doesn’t require approval to be accessed.
Or you could just pay an extra 1 percent of your balance each month on your own accord. After all, there’s no better payment protection than eliminating the debt in the first place.