When it comes to financial options, we tend to favor the idea of paying as little as possible. Who wouldn’t want to pay the lowest price for a new TV? Or the lowest price for a cup of coffee? But there’s definitely one area in finance where paying the minimum will result in paying more over time: making minimum payments on your credit card.
This is a common mistake for many in repayment. It makes complete sense – just pay the bills, right? And whatevers on the bill is the amount to pay? Unfortunately, it’s a mistake that will cost you money (and time). But luckily, small changes to your repayment can have a big impact. In that way, the solution to this common mistake is relatively simple.
What a minimum payment represents
Why are minimum payments so bad? Let’s start by looking at what exactly a minimum payment is. Investopedia defines minimum payments as:
“The smallest amount of a credit card bill that a consumer can pay, to remain in good standing with the credit card company. Making the monthly minimum payment on time is the least a consumer needs to do, to avoid late fees and to have a good repayment history on his credit report. The amount of the minimum monthly payment is calculated as a small percentage of the consumer’s total credit balance.”
Essentially, this means that a minimum payment is the “bottom-line payment.” You must pay equal or above the minimum payments in order to retain good standing with your bank and avoid getting hit with fees or other expense. But it’s essential to note that paying just the required minimum isn’t in the most effective approach to paying off debt for those in repayment. Meeting your minimum payments will keep your credit score happy but these minimum payments lean heavily in the favor of the bank/lender.
Minimum payments weren’t originally created with the borrowers interest in mind
When you make a minimum payment, you’re paying the full interest – but in many cases, not much else beyond that . This is a strategic move by banks and lenders. In order to profit from the loan, the credit card company needs to at the very least gain on the interest. But that means they’re not so concerned with whether you’re paying down your principal balance. In fact, the longer you maintain the principal balance while paying interest, the more money they make from your loan.
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Further proof that minimum payments weren’t created to help the borrower: Several years ago, a bank could get away with billing a mere 1% of the unpaid balance which in many circumstances only just covered the interest or fees. This essentially meant that people paying minimums were on the slowest track to pay off their credit card debt. It’s a fairly new regulation that has minimum payments requirements as high as they are today.
New regulation now requires banks to calculate a minimum payment based on at least 3% of the principal balance. This percent does give a slight edge to the person in repayment, but not by a huge margin. That’s why it’s important to take it to the next level…
Pay above the minimum to get out of debt faster
One of the best things you can do for your repayment is pay above the suggested minimum payment. Even if it’s a small amount each month, paying above the minimums guarantees that at least a portion of your payment goes directly to your principal sum.
Another incredibly useful (and sustainably motivating) step is to create a repayment plan that shows exactly what your repayment will look like. These repayment timelines can help you to visualize how much time and interest you can save by tweaking your approach, and will also illuminate the powerful impact of boosting your payments by even a small amount. For example, consider a $500 loan at a 12% interest rate. Here’s what paying the minimum payments looks like:
It would take you 3 years, 5 months to pay off your debt. You would also be paying an additional $115 in interest which is approximately 23% of the original loan. That’s not a small cost, even if 100 bucks doesn’t feel like much!
Now, look at what happens if you double the minimum payment and make monthly payments of $30 instead of $15.
In this case, you’ll pay off your loan in 1 year and 7 months. You’ll also be paying $52 in interest. That extra $15 makes a significant difference!
A few ways to help you to pay over the minimum:
- Increase your earnings. Most financial advice goes straight to cutting back on expenses, but a great way to add more to your repayment is to earn more that you can then funnel into your payments. For a few ideas of where to get started, check out this post.
- Boost your savings. The above being said, it’s still important to acknowledge the importance of saving. That includes budgeting, laying out your expenses, and pinpointing spending leaks. For more ideas, check out our Budgeting Resource Center
- Pay off using the fastest proven method. One time it’s actually a good thing to pay minimums on a credit card? When you’re paying extra into your highest interest rate loan. This employs the “Avalanche Method” which is mathematically the fastest way to pay off debt. Target your highest interest rate first and then collapsing the payments to the next highest interest rate as you continue to pay off each debt. For a more detailed breakdown, check out this post.
If you can manage to pay above the minimums in your debt repayment, you’re guaranteed to get out of debt more efficiently and effectively. And though it might be tempting to pay the minimums as a way to maintain more disposable income. The more principal balance that you can pay – the better!
For additional resources, you can also check out our ReadyForZero credit card debt resource center!
Image Credit: Nic McPhee