The Real Cost of the Minimum Payment on Your Credit Card
Paying just the minimum on a credit card might feel like a way to keep your monthly bills under control — after all, it keeps your account in good standing and avoids late fees. But that's about all it does; you are barely making a dent in your actual debt this way. Instead, you are paying interest, interest, and more interest on your original charges, while the principal stays essentially the same.
Every card company has its own policy, but the minimum payment is usually the compounded interest for the month plus 1 or 2 percent of the balance. So by paying only the minimums, you are having a nice long jog on the treadmill to nowhere, never making any forward progress on paying down your debt.
And you're not just paying interest on the original amount — which would be called simple interest. You're paying compound interest, meaning you are paying interest on the accruing interest charges. Confused by that concept? You're not alone. Recent research shows that 69 percent of Americans don't fully understand how compound interest works.
There are times when paying only minimums makes sense, like, say, if you are squeaking through a tight cash flow period, due to unexpected medical expenses or a short-term bout of unemployment. But as a long-term strategy for managing (or avoiding managing) debt, it's a recipe for serious trouble.
So here are 4 key facts about the reality of credit card minimum payments — so you can fully understand why you should put them behind you.
#1 You Pay More Than The Original Price — Way More
If you just pay the minimum on your credit card every month, you'll end up paying more for what you bought with the card than you would have if you bought it with cash. Most people understand this in the abstract — but they tend to underestimate just how much more they're paying for things by using a credit card.
So, let's look at an example. Say you bought a new TV with your credit card. The price tag is $1,200. Your credit card's interest rate is 19%. This means your minimum monthly payment, assuming you don't buy anything else with the credit card, will be about $31.
If you pay only the minimum, it will take you 61 months to pay for that TV — more than 5 years! By the time you're done paying it off, you'll probably want a new TV again. (And the TV you bought is now almost worthless, having dropped in value.) More importantly, you'll pay a whopping $672 in interest, more than half what the TV cost in the first place, for a total of $1,872 out of pocket for you. No matter how you slice it, the numbers in this game aren't good.
And too many consumers simply don't understand these numbers. In fact, the federal government passed legislation in 2009 (called the Credit CARD Act) that, in part, required credit card companies to print a "Minimum Payment Notice" on each and every credit card statement, that outlines how long it would take to pay off the existing debt, and what the total cost would be.
Minimum Payment Warning: If you make only the minimum payment each period, you will pay more in interest and it will take you longer to pay off your balance. For example:
| If you make no additional charges using this card and each month you pay... | You will pay off the balance shown on this statement in about... | And you will end up paying an estimated total of... |
|---|---|---|
| Only the minimum payment | 26 years | $24,740 |
| $241 | 3 years | $8,863 (Savings = $16,057) |
Pretty sobering stuff. Basically, if you aren't sure you can pay off your purchase in 3 to 6 months, you should seriously reconsider buying any item. It just doesn't add up. Or put more precisely, it all adds up, and way too fast.
#2 Your Credit Score Takes A Hit
If you're using your credit card throughout the month and then paying only the minimum, you're gradually getting closer to maxing out your card. And even if you don't buy any new items, the interest will keep compounding and adding to the total amount you owe. In addition to paying exorbitant amounts of interest, you are also hurting your credit score, by increasing your credit utilization.
Credit utilization is the amount of your credit limit that's already spent. If you have a credit limit of $10,000 and your current balance is $5,000, your credit utilization is 50 percent. That may seem like a good number — after all, you still have half of your credit left — but it's not. The credit industry thinks an ideal credit utilization rate is below 30 percent — this might be shocking news if you've always thought of your "available credit" as "available cash." But the 30 percent figure is what creditors look for to show that an individual has their spending under control and is not at risk for defaulting on debt (i.e. not paying).
Even people who stay well below the 30 percent credit utilization score will see their credit score drop as they add debt, because no matter what, more debt means more risk. And as higher credit utilization impacts your credit score, it limits your ability to qualify for more credit (whether in credit cards or a mortgage). And a lower credit score can also have a bearing on your ability to rent an apartment or house, your car insurance rates, and your ability to add a utility such as electric or cable (some will require a cash deposit as insurance).
#3 Your Interest Rates are More Likely to Climb
Thanks to the Credit CARD Act passed by Congress in 2009, creditors cannot raise your interest rates willy-nilly just because they feel like it. But they can raise interest rates if they notice that your credit score is dropping, or has dropped by a significant amount due to very high credit utilization caused by your making only minimum payments each month. (Note, that Creditors are required to provide 45-day notice for such an increase, providing time for you to pay down balances or find other options, and there's a mandatory re-evaluation 6 months after the increase.) This new interest rate cannot apply to balances you are already carrying, but it will apply to any new purchases — thus increasing the speed and impact of compounding interest.
But hear this, and consider yourself warned: creditors are permitted to increase the rate on your total balance if you miss two consecutive payments, more than 60 days past due — some companies even issue what's called a "penalty APR," which raises your rate to the highest allowable amount, a scorching 29.99%. This reason, above all else, is why making your payments every month, on time, is so critically important. (Note also that if you make the minimum payment for 6 consecutive months, the penalty APR will generally be removed.) The Credit CARD Act created ways to protect consumers who abide by the rules, but if you step outside those rules, you are no longer protected.
#4 Your Debt Will Begin to Snowball
By paying only the minimum each month, you're creating a debt snowball: you start with what seems like a manageable amount of debt, but since 98% or 99% of the monthly balance carries over to the next month, with compounded interest added, the amount owed starts to grow exponentially. And then anything additional you spend each month will be added to that ever-increasing total. It won't take long before your total debt will start to snowball.
If you are currently unable to cover all your monthly expenses without tapping into your credit, that means you're currently living above your means. This isn't sustainable in the long run — and indicates that your snowball's growth will gain speed, turning it into an avalanche. At this point your debt will become quite literally unmanageable and you'll need intervention of some kind.
The Good News: Every Dollar You Pay Above The Minimum Makes A Difference
Here's the most important takeaway: even if you can't fully afford to pay your entire credit card balances each month, every single extra dollar you can add to that minimum payment will help tip the scales into your favor.
Consider that $1,200 TV example from earlier. Let's say you can manage only an additional $10 each month above the $31 minimum. While that may not seem like much, it will shave a full 21 months off the time it takes you to pay for the TV — almost two years! — and will save you $248 in interest.
This is the positive side of compounding interest — the less interest compounds, the faster you are out of debt. Be fearless in finding those additional dollars, and make it work for you.