The minimum payment makes a frequent appearance in your finances. You see it with every billing statement from a credit card or line of credit, usually next to your outstanding balance.
If you have one of these statements nearby, one quick look will show your minimum is a lot less than your balance owing. At just a fraction of your total statement, you may be tempted to pay just this monthly minimum to save money. But this minimum comes with strings attached. You’ll learn all about them below.
What is a Minimum Payment?
A minimum payment represents the smallest amount of money you have to pay toward a revolving credit account to avoid late fines.
Revolving credit encompasses the world of lines of credit and credit cards. It represents the personal loans that are available on an ongoing (or revolving) basis.
Compare this to most termed installment loans. If approved, you receive an installment loan in one lump sum and have to repay it over multiple, pre-determined installments over time. Once you make your final payment, the account closes. The only way to borrow more is to try to apply for a new loan.
By contrast, a revolving account gives you a credit limit that you draw against. Every draw ties up this limit until you pay it back. Once you pay back your entire balance, you have access to this limit again without having to apply for a new account.
How Are Minimum Payments Calculated?
Banks, online direct lenders, and credit unions calculate this minimum in one of three ways:
- A flat fee, usually around $25.
- A percentage of your outstanding balance, typically between 1% and 3%.
Beyond these two major methods, there’s also a question about what your payment goes towards. For example, payments toward a MoneyKey line of credit include a mandatory principal contribution and a billing cycle charge.
What Happens if You Don’t Pay the Minimum?
Lenders expect you to pay the minimum each other month. Failing to cover this payment can land you in hot water. First, you’ll get a late fine for not paying your balance.
Check out the other consequences below:
- You accrue more interest.
- Your lender may increase your interest rate.
- You may lose promotional rates.
- You increase your credit utilization ratio, which may negatively affect your score.
- You may gain a delinquency in your credit file, which also hurts your score.
What Happens if You Only Pay the Minimum?
Covering the minimum keeps late fines and delinquencies away, but it doesn’t do much else that’s positive for your finances. In fact, it can come with some pretty steep drawbacks:
Delays Paying Off Debt
The minimum is the slowest way to pay off your revolving accounts. In other words, you’ll be in debt longer. If you keep making purchases while only making the minimum, eventually you might even max out your account.
You don’t have to max out your card to get into financial trouble. Since the minimum is only a fraction of your balance, you carry this balance over to the next billing period. It ties up your limit, so you won’t have as much money to draw against in the future.
Credit cards and lines of credit are often financial tools people rely on when things go wrong. Their car needs an emergency fix, and they put it on VISA. But if this account is full, you may have to try your chances by applying for a personal loan or cash advance.
Earns More Interest
Your outstanding balance accrues interest, which folds into your balance every month. By the time you pay off your balance using the minimum, you’ll end up paying a lot more than your original balance due to interest.
Lowers Your Credit Score
The minimum may also affect your credit score if you rely on it a lot. A balance affects your credit utilization ratio, which shows the percentage of how much available credit you use.
Plenty of things may affect your score — some traditional factors and some alternative data points. Your utilization ratio is one of the traditional factors of your score.
Generally speaking, you should aim to keep this ratio as low as possible. A ratio of 30% or higher may harm your credit score.
How Much and How Often Should You Pay?
It’s best to pay your balance off entirely — that is, bring your balance to zero — every month, on or before the due date. You avoid late fines, manage interest charges, and reduce your ratio this way.
Some people like to pay their balances off periodically throughout the month as they make draws. While this isn’t necessary, it might work for you.
- Smaller, more frequent payments space out the impact, which can come in handy if you live paycheck to paycheck.
- Paying more frequently might bring down your balance, which means interest will accrue on a smaller balance.
- It may also be the best way to manage your utilization ratio. Some companies report your balance to the major credit bureaus at different times of the month, so your periodical payments may lower your ratio before they get reported.
Bottom Line
The minimum payment is your eleventh-hour backup when money’s tight unexpectedly one month. But it’s not a long-term way to manage your revolving accounts. Try to always bring your balance down to zero. To do that, start a budget and only draw what you can afford to pay in full.