One of the first things I always see on my online credit card account is the option to make a Minimum Payment. For the longest time, I assumed that making the minimum payment on your credit card debt meant that I would not incur interests for some reason. I know of a couple of other people who had this same misconception.
What is a Minimum Payment ?
The lowest amount that the provider will accept each month. Inability to pay this amount means that your provider may charge you with a late fee.
How is a Minimum Payment amount determined ?
This could be a flat dollar amount, a percentage of the total balance owed or which ever of the two is greater. Some other providers use a base amount plus the interest owed from the previous month as the minimum payment amount. The larger your credit card debt, the higher your minimum payment amounts. The method of calculation varies by providers.
A hypothetical exercise on $2,500 owed
Let’s assume that we have a credit card with an annual interest rate of 18%. We owe $2,500 in Credit card balance. The credit card company determines the minimum monthly percentage as 3%.
We will look at three scenarios next to ascertain the time taken and the extra amount paid depending on how we pay as the monthly amount towards our debt.
Simply making the minimum required payments results in almost 28 years to clear the debt payment. The interest accrued in this scenario is almost the same as the original debt. You now end up owing twice as much as you borrowed in the first place.
I used the calculator on the Government of Canada website to calculate these amounts. Link here.
The cycle of incurring debt is continuous. You can imagine that the Balance owed keeps inflating which in turns inflates the minimum owed payment. Only paying the minimum amount would lead you to be in debt for a much longer period. Preciously why most Personal Finance gurus and Financial Advisors will ask you to first get rid of high interest personal debt or bad debt as a first step to financial freedom.
Minimum Payments can impact your credit scores
If you keep making minimum payments, your balance owed keeps increase. Your available credit (credit limit) remains more or less constant over the year. This results in an increase in your credit utilization over time.
Experts and credit scoring agencies recommend having a credit utilization of 30% or lower. But an increase in the base balance leads to an increase in the utilization rate over time. This implies higher credit utilization leading to lower credit scores. Learn why maintaining a decent credit score is important here.
What to do if you are already making minimum payments today?
Go back to the drawing board and assess how much you owe in credit card debt. In our example above, we see that even making a small extra payment on top of the minimum payment amount reduces the overall interest drastically.
You could consider paying off smaller credit card debt first. This would get you in the mindset of paying off debt. Once smaller debts are paid off, consider moving to larger debts and making additional payments to begin with.
Alternatively, you could direct your energy to paying off the credit card debt with the highest interest rate first. Then direct your energy to the next highest interest rate debt.
In the longer term:
- Consider eliminating credit cards that have higher interest rates.
- Consider getting a new card with a Balance transfer offer/promotion. The provider, here, offer transfer of existing credit card debt to a new card. This is typically at a lower interest rate.
- Consider opting for credit cards that have some annual fee but lower interest rates. This may be a better alternative than a free credit card with very high interest rates.
- Let’s say you have a single card (or two) with not very high interest rate. Consider paying larger debts or higher interest debts in entirety first. If this is not possible, pay additional amounts over the minimum payments systematically each month.