When finances become tight it can be quite tempting to cut back on your credit card payments. After all, if you send in a small payment on your credit card balance you could buy those concert tickets or that new iPhone you’ve been eyeing. Making the minimum payment might even free up funds you need for another bill or necessity.
However, before you start self-justifying minimum payments on your credit card bill it’s important to understand the downside.
The truth is, one of the biggest mistakes you can make when it comes to your credit and finances is to develop the dangerous and expensive habit of making only minimum payments on your credit card debt. And while your card issuers are totally fine with you doing so, it’s not the best course of action — and it’s a hard habit to break.
How Your Credit Card Minimum Payment Works
Your credit card issuer determines your minimum payment each month based on their own internal policies and standards. There is no uniform, industry-wide method used to calculate your minimum payment. Each card issuer is different.
Certain card issuers will require a percentage of your overall balance to be paid as a minimum payment (e.g., perhaps 1% to 3%). Others will require a percentage of your balance plus interest accrued along with any fees (such as late fees) as your minimum payment. Additionally, if your account balance is relatively low, most card issuers will still require at least a fixed minimum payment regardless (e.g., your minimum payment each month must be 3% of your credit card balance or $25, whichever is higher).
Why Making Only the Minimum Payment Is Bad for Your Wallet
Credit card debt is very likely the most expensive debt you’ll ever service, which is a fancy way of saying it isn’t cheap to carry credit card debt. It is not uncommon for credit card interest rates to hover around 15% or higher. In the short term, making only the minimum payment on a credit card might offer you a temporary financial breather — but those high interest rates on the debt will continue to cause your balance to grow quickly.
Let’s assume that you owe $5,000 in credit card debt with a 15% interest rate, which is about average, and a minimum payment of 2% of your overall balance. If you make only the credit card minimum payment each month ($100 in this example), then it would take you 27 and a half years (no, that’s not a typo) to pay off your outstanding debt – and that’s if you don’t put any new purchases on the card in the meantime.
By making just the minimum payment, it would take you almost as long to pay off your $5,000 credit card balance as it would to pay off your entire home mortgage.
Why Making Only the Minimum Payment Is Bad for Your Credit
Making just the minimum payment on your credit card will sting financially, but this bad habit can also wreak havoc on your credit scores as well.
It’s true that making the minimum payment on your credit card will prevent late payments from showing up on your credit reports, and that’s important — paying the minimum is better than not paying at all. However, avoiding late payments is not enough to maintain a great credit score. Credit scoring models like VantageScore and FICO focus on not only how reliably you pay your bills, but also the balances on your cards relative to their credit limits.
Unpaid credit card debt equates to you being an elevated credit risk, period. TransUnion did a study a few years ago that determined people who do not pay their credit card bills in full each month are three to five times riskier than people who do. And, earlier this year, Fannie Mae began considering something called “Trended Data,” which is information from your credit reports that identifies whether you pay off your cards completely every month, or if you carry (or “revolve”) some portion of the balance.
The bottom line is this: Paying the minimum on your credit cards is never, ever a good idea. It’s expensive and it can harm your credit scores. Your best bet is to use credit cards in such a way that you can pay them in full every month, without exception. Then your interest rates become meaningless.
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John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. He has written four books on the topic and has been interviewed and quoted thousands of times over the past 10 years. With time spent at Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.
The post Your Credit Card Minimum Payment Is Just That — a Minimum appeared first on The Simple Dollar.
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