Knowing you won’t be in a position to pay off your credit card balance, you open your monthly statement prepared for the worst. Scanning the balance owed and the amount due, you’re astounded to see the minimum payment is a mere fraction of what you owe. In fact, it’s so small in comparison to what you’d expected, you process the payment right away. Relived, you go on your way, thinking you’re ahead of the game.
Instead, you just stumbled into a trap.
Here’s why making minimum payments is a bad idea.
It’s Better to Pay your Balance in Full
First and foremost, it is important to remember credit card companies are not charitable organizations—regardless of the logo on the card, or who they say a portion of your purchases benefit. Credit card companies exist to make money. They do so by charging interest and fees in exchange for fronting you cash to make purchases.
If you carry a balance from month to month, you will be required to pay interest on the amount of that balance. If you make a payment late, you will be charged late fees. If you miss a payment, your interest rate will be increased. All of these factors congeal into additional debt. Further, that additional debt gets rolled into your outstanding balance, so you wind up paying interest on it too.
Meanwhile, you won’t be subjected to any of these factors if you always pay off your balance before each billing cycle’s grace period ends.
The Hole Gets Deeper
Minimum payments are calculated specifically to keep you indebted to the creditor for as long as legally possible. While they are indeed based upon your outstanding balance—and they take fees and interest into consideration, the proportion of the payment earmarked for principal reduction is miniscule.
Consider what happens if you owe $3,000 at an annual percentage rate of 15 percent and the minimum payment is two percent of the outstanding balance. Factoring it out reveals you’ll need just over 16 years to pay off that $3,000. In the interim, you will pay an additional $3,460 in interest.
In other words, you’ll pay $6,460 and the debt will have more than doubled.
This, of course, assumes you make no additional charges and do nothing to incur fees or an interest rate increase. To find out what your current situation is in this regard, use Clarity Money’s credit card calculator to see how your exact numbers pencil out. You will be amazed at how much you can save by paying more than the minimum each month.
It’s Detrimental to your Credit Score
Paying on time is absolutely a good thing. But there is another almost equally significant factor to consider when it comes to tabulating your credit score. How much do you owe in proportion to how much credit you’ve been afforded?
If you’re carrying a balance from month to month, and you’re only making the minimum payment on that balance, you’re dragging your credit score down. That carryover balance represents a percentage of your available credit in use. This accounts for 30 percent of your credit score. The only scoring factor given more weight is your payment history (which accounts for 35 percent).
These are the primary reasons minimum payments are a bad idea—that is, unless you are a credit card issuer. In that case, they’re one of the best ideas the industry ever conceived. As benevolent as minimum payments seem always remember, credit card issuers are in business to make money. Whenever it looks like a favor is being done, it isn’t being done for you.
It’s being done to you.