Making Minimum Payment on your Loan? Think Again and Save!

Minimum payment and Some Basic Features of a Credit Card

Charges on a credit card are usually billed once a month and Payment of the bill is due in about 25 days. If you pay the credit card bill on-time and in full, you will pay no interest on the amount of the bill. However, if you can’t make the full payment, you can make a minimum payment, or any other amount greater, and avoid late fee. Though, you will still pay interest charges.

Myths vs Facts Regarding Minimum Payments

Myth 1: It’s OK to make minimum payments on a debt.

Well, it may be okay, if you want to pay a high interest rate and be in debt far longer than necessary, which I believe you don’t! Yes, making minimum payment won’t cost you late fees and it won’t have negative consequences on your credit report. But, it’s far more prudent to pay off an account in full every month, or at least increase your payments to something above the minimum.

Myth 2: Carrying a balance will improve your credit score.

Some people think that carrying a balance on their credit cards would help improve their credit score. So, they would make only the minimum payment every month.  However, this is not correct. One should actively use their cards to demonstrate responsible credit use, but it isn’t necessary to carry a balance. If you’re going to use the card on a regular basis, avoid racking up a high balance, which can result in paying interest if you don’t pay it off in full.  Remember, your credit score is an assessment of your overall riskiness in the eyes of the credit card company, not their profitability.

Each credit card company has its own minimum payment policy

Not all credit card companies are similar when it comes to the terms of the minimum payment. Here is some information from some credit card issuing companies. 

• Bank of America:   Past due amounts plus $35 or 1% of the new balance, whichever is greater plus any interest charges and late fees, if any.
  • Chase: Amounts past due plus the greater of: $40 or 1% of the new balance, plus periodic interest charges and late fees, if any, billed on the statement for which your minimum payment is calculated.
  • Citi: $41 or 1% of the new balance, whichever is greater, plus interest if there are no past-due or over-limit amounts.
  • Wells Fargo: $25 or 1% of the new balance, whichever is greater, plus any past due amount, fees and interest.

How does interest work? How is interest calculated on your loan?

It is important to understand that interest is the cost of money one borrows.   It is also important to know the difference between the “Quoted” Interest Rate vs “Annual Percentage Rate (APR) where the latter includes effects of compounding. Take an example of 10% interest rate which is compounded monthly, i.e. 10% ÷ 12 months =0.83% per month. So, it turns out to be 10.47% per year, not 10%. Now, if it is compounded daily? Then, 10% ÷ 365 Days =0.0.27% per day and it turns out to be 10.52% per year, not 10%. In calculating interest on credit cards, the following formula is often used: “Outstanding Balance * Interest % for the period”. This means, more interest paid at the beginning of a loan (or charges made earlier in the month using a card) than the end.

Minimum Payments Mean Maximum Years: An Example

Consider this example. A credit card requires on a minimum 3 percent payment and 15.0 percent annual interest rate (in reality, interest rates on credit cards are even higher). If the original or outstanding balance is $1,000, it will take 8.8 years to repay in full after paying $577 in interest which is 57.7% of the outstanding balance. If the outstanding balance is $3,000, then it will take 14 years to pay off the card amounting to 68% interest rate (total interest paid, $2,005).

Conclusion

This brief article explained why making minimum payments on your credit card is not a good idea at all. Whenever possible, always plan to pay off your credit card debts at the earliest convenience. At the very least, plan to add some extra money to the minimum payment every month which will have very positive effects  both on your credit score as well as your financial position.

By Abdullah Noman, PhD, CFP