If you’re new to using credit cards and are trying to become as knowledgeable as you can, you might feel like your head is spinning. Learning the lingo is tough enough, but you’ll also need to figure out how your credit card issuer does all types of calculations.
Luckily, you have the Nerds in your corner to do the tough stuff for you. If you’re trying to understand how your credit card issuer comes up with your minimum balance, take a look at the information below—you won’t be confused for long!
What is a minimum payment?
Before digging into how your credit card issuer determines your minimum payment, let’s be clear on what a minimum payment actually is. You might be surprised at what you don’t know about this important number.
Simply put, your minimum payment is the absolute smallest amount of money you’re permitted to pay each month toward your credit card balance without incurring fees or triggering negative marks on your credit history. For example, if you have $500 in outstanding charges on your credit card and your minimum payment is $25, you’ll have to pay at least that $25 by your bill’s due date. If you don’t, you’ll likely get hit with a late fee, and eventually your failure to pay will be reported to the credit bureaus.
Nerd note: If you’re on a 0% interest promotion with your credit card, paying at least the minimum every month by your due date is crucial to holding onto the deal. If you miss a payment, you’ll not only get hit with a late fee, but your promotion will likely be canceled and you’ll have to start paying interest right away.
A common misconception about minimum payments is that when you make them you’re avoiding paying interest on your credit card charges. This is not the case! The only way to dodge interest charges is to pay your balance in full each month, so make it a priority to do so (more on that in a minute).
How minimum payments are calculated
Unfortunately, there is no standard formula for calculating your minimum payment; issuers use several different methods. But here’s an explanation of the two most common approaches to coming up with your minimum payment:
Percentage method: Some credit card issuers calculate your minimum payment as a flat percentage of your total balance. The industry standard for this percentage has changed over the years, but today it’s usually between 1% and 3% of your total outstanding charges. For example, if your total credit card balance is $500 and your credit card issuer charges you a minimum payment of 2% of that balance, your minimum payment would be $10.
Percentage + interest + fees method: Another way of determining your minimum balance is to charge a percentage of the total balance (again, usually between 1% and 3%), plus outstanding interest charges and fees. For example, let’s say you have a credit card that charges an APR of 15% and you entered your current billing cycle with $500 in unpaid charges from the previous month. We’ll also assume that you paid last month’s bill late and that your late fee is $35. If you charged $1,000 to your card this month, your minimum payment would be:
$30 (2% of your total balance of $1,500) +
$6.25 (interest charged on the balance you carried into this month) +
$35 (late fee)
With both of these methods, there’s usually also a minimum minimum payment, meaning that if after your minimum payment is calculated it falls below a certain dollar amount, that dollar amount will apply.
The only way to know for sure which approach to calculating your minimum payment your particular credit card issuer is using is to carefully examine your card’s terms and conditions, so be sure to do so before you start using your card.
A minimum payment is just that, so be sure to pay more
It’s absolutely critical to understand that paying only the minimum due on your credit card bill each month is a dangerous habit to get into, for a variety of reasons.
For one thing, if you only make minimums it will take a long time to pay off your balance in full. Consider a scenario where you charge $1,000 to your credit card for a new TV. Even if you make no additional purchases with the card, it will take you almost seven years to pay off that TV if you’re only making minimums.
Plus, there’s the interest charges to consider. In the scenario above, interest is accruing every month that you don’t pay the balance in full. In fact, that $1,000 TV will end up costing an extra $580 in interest if your APR is 15%. Not exactly a bargain!
Worse still, if you make only minimum payments on your credit card and you continue to make new purchases every month, not only are you getting slapped with interest charges and extending the length of time it takes to pay off your balance, you’re also digging yourself into debt. Eventually, this will negatively impact your credit score, which will make it hard to get other loans in the future.
All this means is that you should make a commitment to paying off your credit card bill in full every month—minimums aren’t nearly enough!
» MORE: Credit card 101
The bottom line: Minimum payments are the absolute smallest amount you’re permitted to pay on your credit card balance each month, and your card issuer can calculate this figure in a couple of different ways. But paying just the minimum isn’t a good idea, so be sure to pay the whole balance every time!
Deciphering bills image via Shutterstock