If you’re trying to get out of credit card debt, it’s important to get in the habit of making regular payments on your credit card balance. Making your payment on time is important to avoid late payment penalties and fees. But is it enough to make only the minimum payment on your credit card, even if it’s on time?
As it turns out, making only the minimum payment may be costing you much more than you realize. Here’s how.
Credit is a Business
The minimum payment that your credit card company sets for you isn’t to help you out. It’s calculated to maximize profits for the company. It stretches out the time it takes you to repay and, therefore, how much interest you pay. The minimum payment is usually calculated as a percentage of your total balance, typically between 2 and 4 percent.
Here’s what you are actually paying when you make your minimum payment each month. A typical example would be a credit card balance of $1000, with a minimum monthly payment of 3 percent, or $30. Now, if your interest rate, or APR, is near the standard of 16 percent, that means you owe $160 each year in interest. If you are making only the minimum payments, you’ll end up paying $360 per year toward your credit card balance, but only $200 of that is toward the balance, and the rest toward interest. After one year, your balance will still be $800, and at that rate it will take you quite a while to finally pay off your credit card debt, and most of your payments will be going toward interest. At this rate, it will take you 3 years and 9 months to pay off your credit card, and about $330 in interest.
If you were to pay more than the minimum, say $50 per month, that puts you at $600 in payments per year, with only $160 of that going toward interest. This payment schedule will have your debt paid off in only two years, and with only $171 going toward interest.
Credit Utilization Ratio
Even if you’re fine with your interest rate and understand how much interest you’ll pay over time, making the minimum payment could actually hurt your credit score, even if it’s paid on time. Because while making payments on time does establish a positive payment history, maintaining a high credit utilization ratio is a negative on your credit report. If your credit card balance is over 30 percent of your available credit, then your credit score will suffer. The longer your credit utilization ratio remains over that 30 percent threshold, the worse it will be for your credit score. So if you’re only making the minimum payment on a significant balance, you aren’t making much of a dent in the debt, and you are dragging out the amount of time your credit shows a high credit utilization ratio.
Set a goal to aggressively pay off your credit card debt to save yourself money in the long run and keep your credit report clean, so you can maintain financial freedom and responsibility.