Credit Card Minimum Payment and Credit Score
It would be safe to say that nearly everyone has had a credit card at one point of time. It is pretty rare to find someone who hasn’t applied for a credit card. Credit cards are so prevalent and common, but have you ever stopped and thought how credit cards work?
Credit Card 101
You can think of credit cards as essentially a kind of debt. A credit card issuer gives you a credit card with a credit limit. The credit limit is the maximum that you can spend using that credit card. As you keep making purchases using your credit card, your balance will keep on increasing. This balance is what you have ‘borrowed’ from the credit card company. Every month at the end of your billing cycle, the credit card company will send you a bill detailing your purchases, your balance, the payment due date, and the minimum payment.
Unlike loans where the monthly payments are fixed, credit card companies give you the option to pay the full balance, the minimum payment or any other amount. The portion of unpaid balance will collect interest on it.
Here’s an example: Suppose you have a credit card with a limit of $1,000, and interest rate 15%. If you spend $400 using the card, your balance will be $400, and you have remaining $600 to spend using your card. If at the end of your billing cycle you pay $100, then your remaining balance will be $300. But this balance will accumulate interest. So, by the next month’s billing cycle, you will have an additional amount of around $4 in interest added to your balance.
What is Minimum Payment and how is it calculated?
As the name suggests, the minimum payment is the least amount you have to pay to keep your account in good standing and to avoid paying late fees. Failure to pay the minimum payment can lead to your account marked as past due and may negatively affect your credit score.
Minimum payment is commonly calculated as the maximum of a small amount (usually $10) and a certain percentage (usually 2-4%) of the balance. The exact way that it is calculated will be in the credit card agreement that you should have received when signing up.
How does paying only the minimum payment affect credit score?
Two of the main factors that affect credit scores are regular payments and credit utilization. Learn more about credit scores.
Making minimum payments will ensure that you are up to date on your payments which is good for your credit score.
However, when you pay the minimum payment, it makes only a small dent in your balance. Paying only minimum payment will take a long time for you to bring down your balance. Your balance compared to credit limit is called credit utilization, and a high credit utilization does affect your credit score negatively.
What should I pay?
Here is a simple illustration on how long it takes to pay off a credit card with starting balance of $1,000* (provided, of course, that you are not adding to the balance), when making minimum payment vs. a fixed amount of $100.
|Monthly Payment||Months to pay off balance||Interest paid|
As you can see, making minimum payment only will take years to pay off your balance and you will end up paying a lot more in interest.
So, it is always best to pay off the full balance every month. Any unpaid balance accumulates interest, resulting in an increase in balance. If you are unable to pay off the full balance, you should still aim to pay as much as you can. If times are really tough, at that time you can pay the minimum payment so that your credit score is not negatively affected, but you should get back to paying more towards your credit cards as soon as you can.
Finjoy Capital is not a financial advisory firm.
This article is for informational purposes only and is not a substitute for individualized professional advice.