Did you know that there is a minimum payment warning on every credit card bill you receive? It usually includes a table that spells out how many years and how much money it will take to pay off your debt if you only make minimum payments. Creditors are required by law to include this information. However, most borrowers never look at this information closely, which means that what happens when you make minimum payments remains lost in the fine print.
If you have credit card debt, personal loans, or any other type of debt, it’s important to understand how making minimum payments will affect your repayment.
What are minimum payments?
Minimum payments are the least amount you can pay monthly on your debt without incurring penalties. Every creditor calculates minimum payments differently. Most minimum payments are calculated as a percentage of the principal balance owed.
Typical minimum payments are two to four percent of your principal balance or a fixed floor rate, whichever is greater.
For example, a typical fixed floor amount is around $25 to $35. To remain in good standing, you must pay at least this amount until your principal is less than the floor. Most creditors will ask you to pay off the balance in full when this occurs.
Is making minimum payments a good idea?
Making minimum payments keeps your account in good standing, but it is the slowest and most expensive way to pay back your debt.
Making Minimum Payments Does
- Prevent late fees
- Prevent derogatory marks on your credit score
- Keep you in good standing with your creditor
Making Minimum Payment Does Not
- Save money on your debt
- Pay off debt faster
- Lower your DTI quickly to improve creditworthiness
Minimum Payments Are Not Consumer Friendly
At first, minimum payments seem like a good deal. You can borrow large amounts of money or use credit without having to pay a lot upfront. Unfortunately, paying a little now means you’ll end up paying much more over time.
Minimum payments can extend your debt repayment timeline to 30 years or more, which benefits the creditor!
What happens if you pay more than the minimum payments?
When you pay more than the minimum payment on your debt, you pay down your principal balance faster.
The principal is the total amount you borrowed.
Interest is what you pay the creditor as a fee for borrowing the money.
Every time you make a payment, the money goes toward interest and fees first; whatever is leftover goes toward the principal.
When debt balances and interest rates are high, most of your minimum payment will go toward paying interest rather than paying down the principal balance.
Using this formula, you can calculate how much of your minimum payment is going toward your principal balance vs. interest.
How to calculate the amount paid in interest each month:
- Convert APR to a decimal
- Divide by 12 to calculate the monthly interest rate
- Multiply your monthly interest rate by your current total balance
[ (APR ÷ 100) ÷ 12 ] x TOTAL BALANCE = AMOUNT PAID IN INTEREST EACH MONTH
When you subtract this from your minimum payment, the amount that remains is what goes toward your principal balance.
Examples: The Amount of Principal vs. Interest Paid
Interest Rate: 23%
Minimum Payment Percentage: 3%
|Current Amount Owed
|Amount Paid: Interest
|Amount Paid: Principal
Will making minimum payments hurt my credit?
Making minimum payments prevents you from delinquency which is good for your credit score, but because it is a slow and expensive way to pay back debt, it can still affect your creditworthiness.
DTI or Debt to Income Ratio compares your total debt to your income. Since your income isn’t listed on your credit report, DTI won’t affect your score. However, lenders will look at your DTI, so it can affect your ability to take on new debt as well as the interest rate you receive.
Is there a better way to get out of debt?
Yes, there are many alternatives to making minimum payments that can help you get out of debt faster and for less.
- Pay more than the minimum amount
- Consolidate debt for a better interest rate
- Work with a debt consolidation service
Paying more than the minimum balance increases how quickly you can pay down the principal balance. When less of your money goes toward interest, you’ll save quite a bit over the life of the debt.
Debt consolidation loans can help when you have multiple debts, some or all of which have high-interest rates. If you can consolidate for a lower overall interest rate, you’ll save money and simplify your repayment.
If your debt is overwhelming and you can’t afford to pay more or get a new loan, debt consolidation options may be the right choice for you. Debt consolidation allows you to make a plan for your debts that could reduce the long-term burden. In most cases, you’ll be able to pay off debt years earlier than you would by making minimum payments.
Get Help With Your Debt
Contact a Consolidation Specialist to learn more about the best options for you and your debt. It only takes a few minutes. Accredited Debt Relief does risk-free consultations for folks who are ready to take back control of their debt.