Many people open their monthly credit card statement and don’t have a clue about what it contains – they simply make the minimum payment and forget about it. In the past credit card statements were complicated and difficult to understand, but new government mandates have made statements much more concise, providing you with a clear picture of how much you’re paying on interest, as well as how long it will take to reduce the principle. Once you know where your payments are going, you may think twice about paying only the minimum.
It’s important to know not only how the minimum payment is calculated but when and why fees and penalties will apply. With this information you’ll have a better understanding of ways to reduce your balance, lower your monthly bill and eventually payoff your credit card.
How Minimum Payments are Calculated
Minimum payments vary each month and depend on the size of your balance and the APR on your account.
Most credit card companies calculate minimum payments by using a percentage of the balance, typically between two and four percent. For example, a credit card balance of $2,000 with a minimum payment of 3% would mean a $60 monthly bill. Part of the payment goes toward interest and the rest is applied to the principle. As the balance drops the minimum goes down as well, as long as you’re not adding additional charges to the account.
Most credit card issuers have also established an ‘absolute minimum’ you must pay each month; this figure will be found in the terms and conditions of your agreement. If your calculated minimum falls below this number, you’ll be required to pay the absolute minimum instead.
Interest Charge Calculations
Lenders rightfully expect to be compensated for the use of their capital, and interest is the payment charged to account holders for the privilege. When considering what the minimum payment will be, the interest rate and how it’s calculated is an important factor. If you’re paying too much interest, the minimum payment will hardly make a dent in the balance.
- Adjusted Daily Balance – The most common method for calculating credit card interest. The issuer adds what you owe at the end of each day during the billing cycle and then divides the total by the number of days in the period.
- Adjusted Balance - This is the most favorable interest calculation method and results in the lowest interest charges. Interest is determined by subtracting all payments from the previous billing cycle, without factoring in any new charges.
- Previous Balance – Takes the balance at the end of the previous billing cycle and applies interest to that total. New charges are not included, but this method is more costly than the adjusted balance because current payments (which would lower the balance and thus the finance charge) are not included in the calculation.
- Two-Cycle Average Daily Balance – This is generally the least favorable method for calculating interest, and it’s the least common. It takes into account the average daily balance from the previous two billing cycles to calculate interest charges, so a large average daily balance during either month will create higher interest charges.
Consider Compounded Interest
No matter which method is used, all credit card companies compound interest, essentially charging you interest on previously accumulated interest. For example, if you have a credit card with a 10% APR that uses the average daily balance method, you’ll be charged $40 in interest with an average daily balance of $4,000. Assuming you don’t make any new purchases or payments to your account, the following month your interest charges will be applied to your principle, leaving a total of $4,040 and an even higher interest charge of $40.40.
The longer you carry balances that compound interest, the more money you’re paying straight to the bank. This is why it’s vitally important to pay more than the minimum payment. Also, if your credit card company compounds interest daily rather than monthly, you’ll be paying even more over time.
Why Minimum Payments Increase
There are two reasons why your minimum payment may increase. First, how you handle the account determines whether the minimum payment rises or falls. Continue to charge on the account and the minimum payment increases. The other reason is out of your hands; interest rates are subject to change, at any time, for any reason by your credit card company.
Take Control of Your Payments
Consider the minimum payment required by your issuer as a ‘suggested’ payment and set your own minimum that works to your advantage. Your focus should be on eliminating all compound interest balances and learn to use credit as a tool rather than a source of income. Set a goal to pay a larger self-imposed minimum and never charge more than you can pay off each month.