Credit card debt works differently than debt from installment loans like a home mortgage or auto loan. While monthly payments are standard amounts for installment loans, credit cards typically come with the option to make a minimum payment.
The amount of the minimum payment is less than the total balance, which gives credit card users flexibility. However, due to interest charges, paying the minimum can mean years before the balance is paid off.
If you’re making just the minimum payment on your credit card each month, here’s why you may want to change your payback strategy.
Minimum payments: Eaten up by interest
Minimum payments on credit cards bills are generally about 2-4% of your statement balance. But this minimum payment bundles interest and principal charges together. Much of the time, more of your minimum payment goes towards interest than principal, which means it’ll take longer to pay off your debt.
Here’s an example: Your balance is $2,000 on a credit card with a 17% APR. Minimum payments are 2% of your balance.
Minimum payment: $2,000 x 0.02 = $40
Then you need to calculate how much of this goes towards interest charges, which is where things get a bit tricky. Typically credit card interest is charged based on your average daily balance, not the statement ending balance. The average daily balance is calculated by adding up your balance on each day and dividing by the number of days in the billing cycle. To simplify this example, I’ve assumed the average daily balance is the full $2,000 amount.
Since the APR is really the annual interest you’ll pay, divide this rate (17% in this example) by 12 to get the monthly interest rate. Then multiply by the average daily balance ($2,000):
Monthly interest charges = 17% / 12 x $2,000 = $28.33
Minimum payment counting towards principal = $40.00 – $28.33 = $11.67
As you can see in this example, about 70% of your monthly payment ($28.33 of your $40 payment) covers interest charges. By making the minimum payment, your debt decreased from $2000.00 to $1988.33. Ouch!
Paying off debt this way will take years. How long exactly? According to the calculator from FinancialMentor.com, the debt will take 17 years to pay off assuming you only make minimum payments.
Putting it all together
While credit card interest rates are a concern and don’t help pay off debt quickly, paying the minimum can have the greatest impact on how long it will take to become debt-free.
The key to solving this: don’t think in terms of payments, think in terms of debt. Your focus should be how much your debt costs rather than how much the monthly payment is. As shown above, it can be misleading when so much of your payment goes towards interest and not the principal, meaning you can stay in debt for a long time.
When your bill comes, don’t focus on the minimum payment. Instead, look at the outstanding balance and work to pay off as much of this amount (or, ideally, all of it) when making your payment. Any part of the balance you don’t pay will incur interest charges.
There’s no need to do all the math by hand, either. Use a minimum payment calculator like the one listed above to gain a better understanding of how extra payments can make a big impact. Paying $50 a month rather than the minimum in the example above will save about $2,200 in interest and take five years instead of 17 to pay off the balance.
When it’s okay to pay the minimum
While paying the minimum isn’t recommended for the reasons shown above, there are a few cases where it can make sense.
First off, paying the minimum is always better than not making a payment at all. If you don’t pay at least the minimum amount by the due date, you’ll be hit with a late fee from your card issuer. Worse, late payments are reported to the credit bureaus and can do serious damage to your credit score.
Another scenario when making only minimum payments is okay is if you’re using a debt payoff strategy to target other debt first. If you’re using the debt snowball, pay the most you can on the account with the lowest balance and make just the minimum payment on the other accounts.
If you’re targeting the highest-interest debt first, paying the minimum on other accounts can save money by paying off your most expensive debt first.
(image: Tax Credits)