Minimum payments are part of what can make a credit card a useful financial tool, but they’re also what can keep you in debt longer, sticking you on the debt treadmill and costing you hundreds or thousands of extra dollars in interest.
A minimum payment is the least amount you must pay by a credit card’s statement due date to avoid a late fee. If you’ve used your credit card to cover an emergency or unexpected bill, only making the minimum payment can provide temporary, short-term relief until you’ve adjusted your budget. However, only paying the minimum can snowball your debt and force you to pay more in interest charges in the long term.
For example, if you’re carrying a credit card balance of $7,800 with an interest rate of 15% and you make the minimum payment of $234 per month, it will take you 44 months to pay off the debt, and you’ll end up paying $2,353 in interest.
The interest charged on credit cards is compound interest, which means that interest is calculated every day based on the card’s annual percentage rate (APR) divided by 360 or 365. If you don’t pay off the card’s entire statement balance on the due date, the remaining balance will incur interest, and if you roll over any of that balance to the next statement period, you’ll be paying interest on interest. As of October 2019, the average American credit card interest rate was 17.35% APR. Wowza! That’s high.
How minimum payments are calculated
Minimum payment calculations vary by credit card company, but there are two general methods of setting minimum payment amounts.
The first method is simply a percent of the ending statement balance, usually between 2% and 5%. For example, if your minimum payment is 2% of your balance and you have a $2,000 balance, your payment would be $2,000 X .02 = $40.
The second method combines a percent of the balance, like we saw above, plus interest. For both methods, any penalty fees and past due payments will be added to the minimum total. The credit card company can also add any amount you’ve charged over your credit limit to the required minimum payment.
There are situations when the card company may require you to pay your balance in full, for example If your balance is below a certain amount, like $25. You can find out which method your credit card issuer uses by reading your credit card agreement or calling their customer service number.
As you can see, your minimum payment can vary each month depending on your statement balance, interest rate, and any additional fees. This can make it tricky to budget for your credit card payment every month.
How does paying the minimum affect your credit score?
Making your minimum credit card payment(s) on time, every time, is good for your credit score—around 35% of your score is based on on-time payments. But that isn’t the whole story. Only making minimum payments can negatively affect your credit utilization ratio, which accounts for roughly 30% of your score.
Credit utilization is the percentage of credit available to you that you’re using. So, if you have a $5,000 credit limit on your card and you’re currently carrying a balance of $900, your credit utilization is 18%. Of course, if you’re only making minimum payments and still using the card, or taking on additional debt, like a car loan, your credit utilization ratio is going to go up. Your goal should be to use less than 30% of your total credit limit on each credit card. Less is even better.
How additional payments are applied
Say you’ve needed to make a few minimum payments but now want to put additional money toward paying down your balance. The card company is required to apply any money in excess of the minimum payment to the balance with the highest APR, and then any remaining portion to other balances in descending order of APR. If you have two balances on one card—say a purchases balance with a 15% APR and a balance transfer balance with a 10% APR—any amount you pay above your minimum payment will be applied to the purchases balance first, which has the highest APR