Categories
Finance

How Do Credit Card Minimum Payments Work

Credit Cards have become one of the requisites for proving your financial stability and creditworthiness while also providing boundless convenience in terms of shopping online and physically. It’s a win-win scenario to the end-users, as well as to the companies issuing them in the first place.

Above all, most of the credit cards are free to use, so why shouldn’t we, as consumers, leverage that benefit? Rightly so, it is believed that 191 Million Americans, who are adults, use a credit card, a charge card, or a combination of the two.

That begs the question though: Why are most of the CCs free to use? Typically, CC issuing companies have multiple sources of income, with other diversified investments; specifically, when it comes to CCs, one of the ways they make volumes of money is through the interest they can charge, due to only making the “minimum payments.” (More discussed below). According to NerdWallet, for the CCs approved to regular users like you and me, we are their biggest revenue stream in the form of interest payments. How? Let’s explore the details further; it’s mostly all tied to minimum payments.

why are credit cards free
Haven’t you wondered? Why are most of the credit cards free to use?

What Is a Credit Card Minimum Payment?

As the name suggests, a minimum payment is the least amount of money you are mandated to pay off for every monthly statement.

Usually, the minimum payments achieve three things:

  1. You can continue to use your credit card, or at the least, won’t have to worry about dealing with all the headaches of not paying any amount of money for your bill. There might be situations where certain restrictions may be applied, such as the maximum you can spend, etc. However, it all depends on the terms and conditions of your credit card usage. Either way, most commonly, you shouldn’t run into issues about discontinuance.
  2. You do not get reported as a defaulter/delinquent to the credit bureaus/reporting agencies. When this happens, it can bring a slew of problems, but most apparently, you’ll start seeing being dents in your credit score. Making minimum payments can prevent the chain of events that can lead to this disaster. (Although, I believe you get 30 days before they even start this process. I’d encourage you to confirm with your credit card provider).
  3. You steer clear from late payment penalties.

If all of that sounds great, follow along to learn about the biggest catch in making only the minimum payments.

Why Making Minimum Credit Card Payments Is a Bad Idea?

Making minimum payments will give you another life, so to speak, it won’t work in your favor in the long term. The average annual credit card interest rate is 18.61% for new accounts, and about 15.09% for the older ones. Your exact rate will depend on your credit score, history, etc., but even if you go with 15.09% or for easy math, 15%, that’s a lot.

Basically, on a high-level, when you make a minimum payment only, you owe the remaining balance + the interest that you’ll be charged.

How Are Credit Card Minimum Payments Calculated, and How Do They Tie Into the Interest Rate? In Short, How Do They Work?

Minimum credit card payments use the balance you owe as a base value, and then, it’s calculated either as a percentage of your balance, or a fixed dollar value. The determination between the two is made on the amount of balance you owe. In the majority of the cases, cards with higher balances choose to go with the percentage route.

To understand all of this, let’s use an example. Say you owe $1,000 in credit card balance, and the minimum payment due is 5% of your balance — which in other words, translates to $50.

If you decide only to pay the minimum required, you can continue to use the card, you’ll end up avoiding the penalty for late payments, and will not be reported as delinquent, and life may still be the same for you. However, you’ll also end up owing $950 from the original $1000 balance.

What Happens Next?

Next, you get charged with interest — just because you didn’t make the full payment. Say for easy calculations, it’s $100.

When the entire process of your original balance is over, you walk in with $1,050 ($950 remaining + $100 interest) of balance into the next month/billing cycle.

What Follows After That?

Now, if you don’t use your credit card at all in the next month, you’ll owe $1,050. If you use it, you rack up your new charges on top of the $1,050. From there, if you continue to make minimum payments, you repeat the vicious cycle. Fundamentally, that’s how the entire minimum payment and interest cycle works. And as evident, you can now get an idea of how detrimental this can become.

Coming back to my $100 interest and a 5% minimum payment example, you might have realized that you’ll never get out of debt at these rates. Why? Simply because your minimum payment is lower than the interest that gets charged to you. Technically speaking, when this happens, it’s referred to as negative amortization. And while my example was a hypothetical, this used to exist before the current times.

Now, I believe the system has changed a little when the government stepped in; but the point remains the same: If you continue to make only minimum payments, it will take you a very long time to get rid of your credit card debt. This is assuming you don’t spend anything extra afterwards. If you do, you’ll likely go into a hole you cannot climb out of.

As a general rule of thumb, if you’re curious about estimating your monthly interest, divide your APR% (Annual Percentage Rate) by 12. For example, say your APR was 24%, your monthly interest would be 2%. (24/12).

Best Practices for Not Getting Into Credit Card Debt

Best Practices for Not Getting Into Credit Card Debt

What follows aren’t any official best practices, and I am certainly not a financial advisor, I am confident that you’ll find them useful.

  1. If possible, always pay your balance in full. This is the biggest and the greatest financial justice & respect you can give yourself. If anything, always pay more than the minimum. People tend to forget that while it’s about how much money you make, it’s also about how much you save. In my opinion, they’re both equally powerful.
  2. Only spend on something once, when you can afford that twice. For example, if you can afford two cars, buy only 1. This way, you’ll be comfortable in case of emergencies or increased needs. This is a very general advice, and I understand that you cannot blindly live by it, but for bigger expenses, it really works out well.
  3. If you have to make minimum payments because of some financial constraints, go for it. But always strive for paying off the entire debt. Don’t let minimum payments become your habit. They’re undoubtedly enticing, but not the best of the solutions in the long run and not the smartest of choices when it comes to a financial lifestyle.
  4. There’s an alternative for inevitable large expenses — that you know you cannot afford: Try applying for a new credit card with 0% APR. Customarily, you’ll get no less than 12 months of interest-free credit card usage.

The bottom line is, be smart, deliberate, and prudent with your expenses.

You May Also Want to Check Out:

Conclusion

As a consumer, it’s never sensible to make only the minimum payments. Nevertheless, if you absolutely need to (and understandable), be aware of what you’re getting yourself into.

The last thing you’d want is creating a habit of paying only the bare minimum. The Credit Card companies would love that; however, it will not do you any favors as you’ll end up paying huge amounts of interest.

Remember: Clearing only the minimum balance from your credit card monthly billing cycles can hold you back from financial freedom, more significant life purchases such as a house or a car, and worse case, your retirement.