Credit cardÂ billsÂ can be confusing. If everything was straightforward and clear,Â credit cardÂ debtÂ wouldn’t be such a big issue. But it’s not clear, and debt is a massive issue for millions of consumers.Â
One of the most confusing aspects is theÂ minimum payment, with few consumers understanding how this works, how much damage (if any) it does to theirÂ credit score, and why it’s important to pay more than the minimum.
We’ll address all of those things and more in this guide, looking at howÂ minimumÂ credit cardÂ paymentsÂ can impact yourÂ FICOÂ scoreÂ and yourÂ credit report.
TheÂ minimum paymentÂ is the lowest amount you need to pay during any given month. It’s often fixed as a fraction of yourÂ total balanceÂ and includes fees and interest. Â
If you fail to make thisÂ minimum payment, you may be hit withÂ late feesÂ and if you still haven’t paid after 30 days, your creditor will report your activity to the majorÂ credit bureausÂ and yourÂ credit scoreÂ will take a hit.
When this happens, you could lose up to 100 points and gain a derogatory mark that remains on yourÂ credit reportÂ for up to 7 years.Â MakingÂ minimum paymentsÂ will not result in a derogatory mark, but it can indirectly affect yourÂ credit scoreÂ and we’ll discuss that a little later.
Firstly, it’s important to understand why you’re being asked to pay aÂ minimum amountÂ and how you can avoid it.
Prior to 2004,Â monthly paymentsÂ could be as low as 2% of the balance. This caused all kinds of problems as most of yourÂ monthly paymentÂ is interest and will, therefore, inflate every month so that every time you reduce the balance it grows back.Â
Regulators forced a change when they realized that some users were being locked into a cycle ofÂ credit cardÂ debt, one that could see them repaying thousands more than the balance and taking many years to repay in full.
These days, a minimum payment must be at least 1% of the balance plus all interest and fees that have accumulated during that month, ensuring the balance decreases by at least 1% if only theÂ minimum paymentÂ is met.
If you have a rolling balance, you need to make the minimumÂ monthly paymentÂ to avoid derogatory marks. If you fail to do so and keep missing those payments, your account will eventually default and cause all kinds of issues.
However, you can avoid theÂ minimum paymentÂ by clearing your balance in full.
Let’s assume that you have a brand-newÂ creditÂ cardÂ and you spend $2,000 in the first billing cycle. In the next cycle, you will be required to pay this balance in full. However, you will also be offered aÂ minimum payment, which will likely be anywhere from $30 to $100. If this is all that you pay, the issuer will start charging you interest on your balance and your problems will begin.
If you spend $2,000 in the next billing cycle, you have just doubled your debt (minus whatever principal theÂ minimum paymentÂ cleared) and your problems.
This is a cycle that many consumers get locked into. They do what they can to pay off their balance in full, but then they have a difficult month and thatÂ minimum paymentÂ begins to look very tempting. They convince themselves that one month won’t hurt and they’ll repay the balance in full next month, but by that point they’ve spent more, it has grown more, and they just don’t have the funds.
To avoid falling into this trap, try the following tips:
You may have heard experts recommending that you pay more than the minimum every month, but why? If you’re locked into a cycle ofÂ credit cardÂ debt, it can seem counterproductive. After all, if you have a debt of $10,000 that’s costing you $400 a month, what’s the point of taking an extra $100 out of your budget?
Your interest and fees are covered by yourÂ minimum paymentÂ and account for a sizeable percentage of thatÂ minimum payment. By adding just 50% more, you could be doubling and even tripling the amount of the principal that you repay every month.
What’s more, your interest accumulates every single day and this interest compounds. Imagine, for instance, that you have a balance of $10,000 today and with interest, this grows to $10,040. The next day, the interest will be calculated based on that $10,040 figure, which means it could grow to $10,081, which will then become the new balance for the next day.Â
This continues every single day, and the larger your balance is, the more interest will compound and the greater theÂ amount will be dueÂ over the term. By paying more than yourÂ minimum paymentÂ when you can, you’re reducing the balance and slowing things down.
Paying theÂ minimum amountÂ every month ensures you are doing the bare minimum to avoid hurting yourÂ credit historyÂ or accumulating fees. However, it can indirectly reduce your score via yourÂ credit utilizationÂ ratio.
YourÂ creditÂ utilizationÂ ratioÂ is a score that compares theÂ credit limitÂ of allÂ availableÂ creditÂ cardsÂ to the total debt on those cards. It accounts for 30% of yourÂ credit scoreÂ and is, therefore, a very important aspect of theÂ credit scoringÂ process.
The moreÂ credit cardÂ debtÂ you accumulate, the lower yourÂ credit utilizationÂ rateÂ will be and the more your score will be impacted. If you only pay the minimum, this rate will become stagnant and may take years to improve. By increasing theÂ payment amount, however, you can bring that ratio down and improve yourÂ credit score.
You can calculate yourÂ credit utilizationÂ score by adding together theÂ totalÂ amountÂ ofÂ creditÂ limitsÂ and debts and then comparing the latter to the former. A combinedÂ credit limitÂ of $10,000 and a balance of $5,000, for instance, would equate to a 50% ratio, which is on the high side.
As withÂ interest charges,Â credit cardÂ fees will not directly reduce your score but may have an indirect effect. Cash advance fees, for instance, can be substantial, with manyÂ credit cardÂ companiesÂ (includingÂ Capital One) charging 3% with a $10 minimum charge. This means that every time you withdraw cash, you’re paying at least $10, even if you’re only withdrawing $10.
What many consumers don’t realize is that these fees are also charged every time you buy casino chips or pay for some other form of gambling, and every time you purchase money orders and other cash products.Â
Along with foreign transaction fees and penalty fees, these can increase your balance and yourÂ minimum payment, making it harder to make onÂ time paymentsÂ and thus increasing the risk of aÂ late payment.
Does Paying the Minimum Hurt Your Credit Score is a post from Pocket Your Dollars.