According to a study completed by the National Bureau of Economic Research, it was found that up to 20% of people only pay the minimum payment on their credit cards even when they could afford to pay more. Paying the minimum payment may seem like the easiest route to take, however, it can seriously affect your financial goals. Keep reading to learn more about minimum payments and why you should always try to pay more than the minimum due.
What is a Minimum Payment?
Once you get your credit card bill, you generally have multiple options for payment: the minimum due, the statement balance, and the current balance. Your minimum payment is the amount you must clear by the given deadline to keep your account active and in perfect standing. You might harm your credit score if you pay less than the minimum or skip a payment. Furthermore, while you should consistently pay at least the minimum amount required, you should try to pay off your debt in full to avoid paying hefty interest charges.
How Minimum Payments Are Calculated?
Your interest rate and the monthly amount usually decide minimum payments. In some cases, such as when your account balance falls below a specific limit, you may be charged a predetermined sum, such as $25 or $35. Usually, one of the only exceptions is if your total debt is less than the predetermined minimum payment amount, in which event you will be required to pay the entire balance. For people with balances above a specified limit, the minimum payment can be determined in various ways, including a flat percentage of the total balance or a percentage plus the cost of interest and fees. Based on the card provider and the terms of your contract, one of these approaches might be used to estimate your minimum payment. If your card company charges a flat percentage, your minimum payment may range from 2% to 4% of your entire debt. The interest and fees will be subtracted from the total percentage determined in this instance. If they adopt the alternate approach, you will pay a smaller flat percentage, typically about 1%, but you will still be charged the relevant interest and fees for that timeframe.
Disadvantages to Paying Only Minimum Payments
Takes Longer to Pay Off
Credit card companies frequently establish extremely low minimum payment requirements. In most cases, you'll owe either a fixed fee, usually $25, or a percentage of the amount. Some cards ask you to pay only 1% or 2% of the balance monthly, plus any fees and interest. Making these little payments on time will save you from incurring late penalties, but you will make no significant progress toward paying down your total amount. Examine your credit card bill for the "Minimum Payment Warning." There should be a table that provides information on how much money you'll need to pay off your amount and how many years it would take if you merely pay the minimum each month. If you can’t find that table, don’t worry, we’ll discuss an example of one a bit later on.
You Will Gather More Interest
Your interest rates will rise in conjunction with your balances. If you simply make the minimum payment, you'll scarcely cover the interest from the previous month. Furthermore, if you continue to charge merchandise on your card, you'll find yourself falling more and more behind. Divide your card's annual percentage rate by 12 and multiply it by your average balance to estimate your interest charges. If your card has a 21% APR, for example, your monthly interest rate would be 1.75%, or 21% divided by 12. Multiply that by the balance you're carrying.
Your Credit Score Could Suffer
When your credit card balances increase, so does your credit utilization ratio, which is the amount of your available credit that you're using. Your credit utilization ratio is a crucial aspect of your credit score. This makes it more challenging to qualify for loans and credit cards with favorable conditions if you’re using a high percentage. It can also have an impact on your ability to get work or rent an apartment, as employers and landlords frequently check applicants' credit. It's better to utilize no more than 30% of your credit limit on any individual card. It's even better if you can use less.
Bonus: What is Loan Amortization Schedule?
Remember earlier when we mentioned a table that provides information on how much money you'll need to pay off your amount and how many years it would take if you merely pay the minimum each month? That table is known as a loan amortization schedule, and while it is typically associated with loans for cars and houses, it can also be used for your credit card. In loan amortization, a part of each installment is used to pay interest, while the remainder is used towards the loan principal. A loan amortization calculator or table template is the most straightforward approach to determine payments on an amortized loan. Nevertheless, you may evaluate minimum payments by yourself with only the loan amount, interest rate, and loan period. To help you get started on creating your own amortization schedule, check out the example we included below:
Step 1: Start by figuring out the minimum payment required by your credit card company. That number is typically based on your balance. Your card issuer determines your minimum payment, so you may need to ask which number to use. In our example, the card requires us to pay 5% of our outstanding loan balance. We currently owe $500 on our credit card. The minimum payment is 5% of $500, or $25. To find that answer, we multiply $500 by .05.
Step 2: When you make a payment, your entire payment amount usually never goes entirely towards paying off the principal amount you owe because your creditor likely takes out some for interest. In our example, during our first payment, you can see that of the $25 we paid, only $20 went towards paying off the balance. To find the amount of interest paid, you’ll need first to find the interest rate you pay on your card, in our example it is 12% APR. Next, convert that annual rate to a monthly rate by dividing by 12 —because there are 12 months in a year—so, in this example, you’d pay 1% per month. Next, multiply the monthly rate by your outstanding balance. In our example, at month 0, our outstanding balance was $500; when we multiply that by .01, we find that $5 of our $25 payment goes towards interest.
Step 3: After you pay interest, the remainder of your payment goes toward your “principal” part of your loan or the loan balance. To find this, you simply subtract the interest charges from your total payment to figure out how much principal you pay off in any given month. In our example, our payment was $25 with $5 going to interest, so our calculation to perform is $25- $5. When we complete this, we find that $20 went to the principal and that our new credit card balance is $480
Step 4: Now that you’ve completed the first row, you’re reading to finish out your schedule! For each month, you’ll perform the same calculations, with the exception being that you’ll use the new loan balance each month.
Schedule A Consultation with an Experienced Financial Advisor
Here at Fourth Avenue Financial, our first priority is your overall financial success. We want to help you develop, implement, and monitor a strategy designed to address your individual situation to ensure all your investments are setting you up for a path of financial success. If you are ready to start planning for your financial future, we are here to help. Contact us today at (304) 746 7977 to schedule a meeting with one of our experienced financial advisors or schedule online: https://calendly.com/fourthavenuefinancial/introductory-zoom.
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