Why You Should Always Pay More on Your Credit Card than the Minimum Payment

The coronavirus has been devastating for millions of people around the world. It has been tough on financial security as well. Many people have been left without jobs while others have had to cut back their full-time hours to work part-time positions. As a result, many people have been forced to live off of their credit cards since the pandemic began. This can be dangerous if you don’t have a plan to pay your credit card(s) debt back down. 

While trying to make ends meet, it can be tempting to get into the habit of only making the minimum payment on your credit card each month, but that is a sure way to rack up debt quickly. Virtually all personal finance advisors tell their clients to make more than the minimum payment on all of their credit cards if they possibly can. If not, you may have to explore other options. This article will explain why it’s best to avoid making just a minimum payment and how you can avoid falling into this trap.

Making only the minimum payment on your credit card is a bad long-term strategy.

In a nutshell, a credit card minimum payment is simply the minimum amount of money you must pay each month to remain current on your debt. As long as you make that minimum payment, your account remains open and you can continue to use the card, provided you have not reached your spending limit.

While making just the minimum payment is not a good long-term strategy, in the short-term it is better to make the minimum payment than not to pay anything at all. Doing so ensures that you will avoid late fees and penalties, which can add a lot to your debt. If you don’t make at least the minimum payment your account can also be reported as delinquent on your credit report, which can hurt your credit score.

That said, making the minimum payment is not a good long-term strategy because it barely chips away at the amount of principal that you owe on the card. Much of your minimum payment actually goes toward the interest on the principal. So, making the minimum payment doesn’t do much to help you get out of debt. It is also good to keep in mind that a credit card company earns profits from the interest that you pay it, so it is often in the company’s own best interest to keep you paying interest on your debt for as long as possible.

Paying Down a Debt Takes Much Longer

If you only make the minimum payment on your credit card, it can take years to pay it off in full. One of the trickiest things about credit card interest is that it compounds, or adds to itself. For instance, if you make a purchase with a card that has no payments due for the first six months, the balance at the end of the first billing cycle would be the total cost of the thing you purchased. But then you are charged interest on the balance and that interest is added to the amount you owe. 

The next month, the interest will be calculated on the new amount (the original purchase price plus last month's interest charge). Depending on the interest rate and the balance on the card, it’s possible that the minimum payment you are making is only covering new interest charges each month. If this is the case, no matter how many payments you make at the minimum rate, the balance of the debt you owe will never actually decrease. Knowing your interest rate and exactly how much is being added to the debt each month will help you figure out how long it will take to pay off the debt. This information can usually be found on your credit card statement.

It Will Lead to Bigger Interest Charges

Many people don’t realize exactly how much they are paying in interest charges when it comes to credit cards. Because interest compounds over time, the longer that it takes you to pay down the debt, the more you will pay in interest charges. By making only the minimum payment, you will pay a lot of money in interest. 

Say that Horace has a Capital One credit card with an outstanding balance of $8,000. His card is charging him an annual percentage rate of 27%. He makes his minimum payment of $280 each month. At this rate, it will take him 47 months to pay off the full balance of his card, and he will have paid a total of almost $13,000 at the end of that period. If he were to make a monthly payment of $500 per month instead, he would pay off his card in full in 21 months and save himself about $3,000 in interest charges. 

Credit Scores Could Be Adversely Impacted

To be sure, making the minimum payment on a credit card is much better than not making one at all. You’ll avoid penalties and late fees when you make the minimum payment, and it may also improve your credit score, at least for a while. But this is a bad long-term strategy because you are accumulating high-interest debt and also hurting your credit score because of your poor debt to credit ratio. 

When calculating your credit score, credit rating agencies, such as TransUnion, Equifax, and Experian, like to see most consumers use only about a third of their available credit and then stay current on that credit over time. It’s easy to rack up blemishes on your credit report from credit cards that have been overutilized, but this can cost you thousands in the long run. Poor debt management and credit utilization can take years to balance out on your credit score.

How Credit Card Issuers Calculate Minimum Payments

Knowing what your minimum payment will be in a given month can be useful if you are short on cash for that month. When a cardholder owes less than $25, the minimum will generally be the full balance. If they owe between $25 and $1,000, the card issuer may charge a fixed amount like $30. If the cardholder owes over $1,000, the minimum will generally be about 2% of the balance. There are two main methods that most credit card companies use to calculate your minimum payment: a flat percentage or a formula. 

Flat Percentage

Some credit card companies, such as subprime lenders and companies that issue cards to those with bad credit, calculate their minimum payments by simply using a percentage of the outstanding balance. Many of them then tack on other fees, such as finance charges and monthly or annual fees. For example, a cardholder with a credit card balance of $10,000 on their card may be charged a minimum monthly payment of 2% of their balance, or $200. If the card charges a 24% interest rate, the interest charge would be $200 (24% X $10,000 = $2,400 / 12 months = $200). So, the total minimum payment would go largely towards the interest being charged, with very little of it going to repay the principal debt.

A Formula 

Some credit card companies calculate their fees according to the amount of interest that you owe. The interest rate that is charged is about a twelfth of the amount of interest that is owed. So if you owe at least $12,000 and are charged an interest rate of 12%, then your monthly payment will include an amount of at least 1% for the total balance owed, or $144. But this amount may be increased by other monthly fees and charges, such as over-limit fees or other monthly amounts. Just know that the credit card companies are restricted in what they can charge you for various types of debt (i.e., purchases, balance transfers, cash advances). The fixed minimum is usually less than the other types of minimums that are used by credit card companies, but it is still valid. The Credit Card Act of 2009 resulted in major changes in the ways that credit card companies can behave and the information that they must provide. Issuers must now disclose the amount of time that it will take to pay off a credit card balance, even if it has gone to collections. 

Other Factors Affecting Minimum Payments

If you are past the due date on your minimum payments or have exceeded your credit limit, you will be subject to additional charges (such as late fees and over-limit fees) as well as additional interest on your past due amount. There are also usually additional fees for cash advances or other special services. 

These fees - which could be as high as $20 or $20 - can be added to your minimum payment, making it considerably higher. Trying to make your minimum payment and pay off these fees can feel like a losing battle. Many credit card companies make a lot of profit on fees alone, and they can keep many cardholders in financial bondage for years. 

It is also important to know when your credit card’s billing cycle begins and ends because it often doesn’t begin at the beginning of the month. Check your credit card statement to see when your monthly cycle begins. 

How to Avoid the Minimum Payment Pitfall

To pay off your credit card debt, start by creating a budget to see what expenses you can reduce. Everyone should have a good budget, regardless of whether they have credit card debt or not. Having a budget is especially helpful if you need to make a plan to pay off your debt, but you’ll need to stick with it. Credit cards make it very easy to live beyond your means and buy things when you don’t really have the money to do so. To stick with your budget, try not carrying your credit cards with you to avoid impulsive spending. Budgeting can be a key line of defense against this temptation. 

If you’re trying to get ahead of your debt, you may be able to move the balance of your high-interest credit cards to a low or no-interest credit card via a balance transfer. You’ll need a decent credit score to do this. And if you do fall behind, don’t despair. Most credit card companies are willing to negotiate with you to keep your account from charging off, but you’ll need to contact them to ask what your options are. They would rather keep your account in good standing than write it off as a loss or sue you, so don’t hesitate to contact your credit card company if you become delinquent with your payments.

If you implement the strategies above and you are still struggling with credit card debt, it may be wise to visit a nonprofit credit counseling agency to see what your options are. You may be eligible for a debt relief program or a debt repayment program that can help you to organize your finances and pay off your debts. You can also create a debt repayment plan on your own. There are many free online resources you can use to see exactly how long it will take you to pay off your debts and how much interest you will pay over time.

You can also try the debt snowball or a debt avalanche method to tackle your debt. With the debt snowball method, you’ll make all monthly payments on all of your debts then put any extra money available toward your debt with the smallest balance. When that debt is paid off, you’ll use the money you were using for that debt, including the extra payment, on your next smallest debt until it is paid off. As you pay off debts, the amount you’ll have to pay off other debts snowballs. 

The debt avalanche is similar, but instead of starting with the debt with the lowest balance, you’ll start with the debt charging the highest interest rate. This will save you a lot of money in interest charges in the long run, but you might not feel like you’re making as much progress because you won’t see the debts disappear as quickly. Both methods work, but one could work better for you than the other.  

Let’s Summarize...

Credit cards can be very useful financial tools for those who know how to use them correctly. The best credit cards offer many incentives, such as cashback or discounts on travel. But they can be very damaging for those who only make the minimum payments on their cards and run their balances up. Be sure that you know what interest rate your card is charging you and when your billing cycle begins. Always stay in touch with your credit card company if you fall behind so that you’ll know what your options are. Consult with a nonprofit credit counseling service for more information on credit cards and how they can help or hurt you.