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What is a minimum payment on a credit card?
A minimum payment on a credit card is the lowest amount that must be paid each month to avoid late fees and maintain a good credit standing. This payment keeps the account active and may help prevent default if multiple payments have been missed.
Read on to learn how minimum payments work and why sticking to them is an important part of financial health.
How do minimum payments work?
Minimum payments are typically calculated as a percentage of the outstanding credit card balance or a flat fee, whichever is higher. For example, a common calculation might be 1-2% of the total balance on a credit card or a fixed dollar amount, such as $35.1
This payment is the lowest amount required to avoid a late fee. However, it is important to know that a minimum payment may not be enough to cover interest for the entire balance. This means that credit card interest will be applied to the rest of the balance.
Grace periods play a significant role in managing minimum payments. A grace period refers to the time a customer has to pay their credit card debt between the end of a billing cycle and the payment due date. Paying off the entire balance within this period may help avoid interest charges.
Other factors can also increase the minimum payment amount set by the credit card issuer. These factors may include pending interest charges and any late fees from previous billing cycles. It’s important to keep up with minimum payments to prevent these fees from building up. One way to do this is to regularly check credit card statements to stay up to date.
What happens when making only the minimum payment?
Potential impacts of making only the minimum credit card payment include:
- Increased debt: Minimum payments usually only cover a portion of the outstanding credit balance. This means that, over time, the total credit card debt will increase due to compounding interest. This occurs because the interest rate applies to the principal balance plus accrued interest. So, interest accrues on interest.
- Negative impact on credit score: Consistently making only minimum payments on a credit card can lead to a high credit utilization ratio. This is calculated by looking at the percentage of available credit that customers are using. A high credit utilization ratio can negatively impact one's credit score, making it potentially difficult to obtain loans or favorable interest rates in the future.2
- Longer repayment periods: Making only minimum payments can significantly extend a repayment period. This means that it could take longer to pay off the debt, and more interest will be paid over the life of the debt.
Calculating the cost of minimum payments
Here is an example of how interest charges increase when only making credit card minimum payments.
If someone has a $5,000 credit card debt with an annual percentage rate (APR) of 24% and a monthly minimum payment of 2%, their initial payment is $100 in the first month.
Making this payment will see the rest of the balance accrue interest of $73.50, leaving a new balance of $4,973.50. For the second month, the payment would be $99.47, but with $73.12 in added interest after payment. Continuing this way, most payments go toward interest, extending repayment to over 20 years and resulting in the customer paying more than $8,000 in interest.
This minimum payment calculation is an example of how paying the lowest possible amount on your credit card can add up over time.
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Alternatives to making minimum payments
There are alternative strategies to managing credit card debt beyond minimum payments. These include:
- Making larger monthly payments: Larger monthly payments can shorten the repayment period, lower the amount of interest, and reduce the overall cost of borrowing.
- Balance transfer offers: Balance transfer offers can consolidate multiple high-interest debts into a single lower-interest account. While this strategy can lower interest, one should be aware of balance transfer fees and how long initial lower interest rates will last.
- Setting up automatic payments: Automatic payments can ensure that at least the minimum payment is made on time, avoiding late fees and potential negative impacts on credit scores.
- Debt consolidation: This process involves combining multiple debts into a single loan with a potentially lower interest rate, simplifying repayment, and reducing overall interest costs.
Responsible credit card usage
Responsible credit card use is crucial for maintaining financial health and avoiding debt. Paying a credit card balance in full every month can help cardholders avoid debt and maintain a healthy credit score. Furthermore, it is essential to spend only what can be repaid on time. Consider using an app, such as the PayPal app, or an expense tracker to help stay on top of bills, monitor transactions, and manage finances.
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