When your credit card statement arrives, you’ll notice it contains an option to make the minimum payments on credit cards. This figure is the lowest amount you must pay by the due date to keep your credit card account in good standing. It’s typically a tiny fraction of your total balance.
Occasionally paying the bare minimum is fine, especially if you’re grappling with a tight budget. However, using this payment strategy habitually is a recipe for future financial trouble.
Routinely paying only the minimum can wreak havoc on your budget and damage your credit standing over time. And it can cause your credit card debt to snowball to the point where you’re struggling to repay what you owe.
In this article, we’ll explore how minimum payments on credit cards work and the long-term consequences of relying on them too liberally. And we’ll review some payment strategies you can adopt to pay off your balance sooner than later.
How does a credit card minimum payment work?
Credit card minimum payments allow you to repay a small portion of your statement during a billing period. This feature lets you conveniently lower your payment size if your household is experiencing cash flow problems while keeping your account current.
So long as you pay the minimum amount by your statement’s due date, your card issuer will deem your payment to have been made on time. As a result, they won’t report it as a late payment to Canada’s credit bureaus.
On average, the quality of your payment history accounts for 35% of your overall score, so you want to avoid being tardy as much as possible.
How is the minimum payment calculated?
Credit card providers typically determine the minimum payment using one of two methods:
- Flat rate
- Percentage of the outstanding balance or a fixed amount, whichever is higher
Under the flat rate method, you pay a small, fixed amount, say $10, regardless of your card’s balance. Additional interest and fees accrued from the prior billing period may also apply. If your balance owing is less than the fixed amount, it automatically becomes the minimum payment.
Under the percentage method, your card issuer uses a percentage of your total balance, usually 2% – 3%, to set your minimum. This practice is more prevalent among card issuers than the flat rate method.
How is the minimum payment applied when you pay it?
Federally regulated financial institutions are free to decide how to apply your minimum payments to your card’s balance. While policies may differ among card issuers, a common practice is to allocate the minimum payment in the following order:
- Interest
- Fees
- Transactions
Under this policy, your minimum payment will first clear any interest charges or fees on your statement. Whatever remains gets applied to your card’s balance. The Royal Bank of Canada (RBC) employs this payment application method, as does the Canadian Imperial Bank of Commerce (CIBC).
Suppose a credit card account balance is subject to different interest rates (for example, a purchase rate and cash advance rate). In that case, your bank will usually apply what remains of the minimum payment toward the portion of the balance with the lowest rate.[m1]
Do you get charged interest if you pay only the minimum?
If you contribute only the minimum payment each billing period, there’s no way to escape interest charges. The reason is that you lose your grace period.
The grace period refers to the time frame (usually 21 days) between the end of your card’s billing date and the payment due date. If you repay your balance in full by the due date, you’ll avoid having to pay interest charges for that billing cycle.
Naturally, your balance will carry past the due date if you only pay the minimum. As a result, interest will immediately begin collecting on your unpaid balance and any new purchases.
What happens if you only make the minimum payment on your credit card balance?
If you consistently make minimum credit card payments, two things will happen:
- It’ll take longer for you to pay off your balance, and
- You’ll pay a tremendous amount in interest charges
An example will help to illustrate this concept. Suppose you charged $1,500 worth of purchases to your card during a single month. Your interest rate is 19.99%, and your card issuer calculates your minimum payment as 3% of the balance.
Let’s assume you’re considering the following payment plans:
- Pay only the minimum
- Pay the minimum plus $50
- Pay a fixed amount of $200
Here’s how the three scenarios would play out (a minimum credit card payment calculator can help you quickly crunch these numbers):
| Option A: Minimum Payment | Option B: Minimum Payment + $50 | Option C: Fixed Payment of $200 | |
| Original balance | $1,500 | $1,500 | $1,500 |
| Time to pay off balance | 13 years and 6 months | 2 years and 1 month | 9 months |
| Total interest paid | $1,613.83 | $307.44 | $115.75 |
| Total amount paid | $3,113.83 | $1,807.44 | $1,615.75 |
| Amount saved | – | $1,306.39 | $1,498.08 |
| Time saved | – | 11 years and 5 months | 12 years and 9 months |
As you can see, if you stick to paying the bare minimum each month, it’ll take you over 13 years to fully repay what you owe. In stark contrast, opting for a fixed payment of $200 will enable you to settle your balance in only nine months.
In addition, paying just the minimum will drain a lot of money from your bank account – you’ll pay a whopping $1,683 in interest charges. This amount actually exceeds your original balance! Conversely, paying $200 each billing period will be far more effective in minimizing your interest costs. You’d pay just $115 over nine months.
The positive impact of adding just $50 on top of your minimum is also worth noting. You’d save $1,807 in interest charges and pay off your balance over 11 years sooner under this payment plan.
The consequences of paying only the minimum on your credit card
Here are the real-life implications of paying only the lowest amount required on your credit card balance:
Strained Budget
With interest charges mounting and your credit card balance dwindling at a snail’s pace, you’ll have less money available for household expenses and other debt payments.
And if you encounter financial difficulty, perhaps through a job loss, your budget will face even more pressure. In such scenarios, every spare dollar counts to stay afloat financially. Your growing credit card balance will worsen your situation as it consumes your budget.
High credit utilization ratio
The credit utilization ratio is a financial metric that measures how much credit you’re using relative to your credit limit. It has a significant influence on your overall credit score.
A low ratio means you’re using little of what credit is available to you, while a high ratio means you’re using a lot. Naturally, the higher the ratio, the greater your risk of defaulting on your payments. Thus, your credit score will drop if your credit utilization remains consistently high.
Since minimum payments elevate your credit utilization, credit bureaus may downgrade your credit score. And the lower your score, the more challenging it’ll be for you to qualify for competitive interest rates on loans.
High debt-to-income ratio
The more debt you owe relative to what you earn, the more hurdles you’ll face securing financing for a mortgage, line of credit, personal loan, etc. Lenders will regard you as a high-risk borrower, given how much of your income you already dedicate to existing loans.
A credit card balance that persists for years will only work to increase your debt-to-income ratio. It can also adversely affect your ability to find a home to rent, as landlords frequently review credit reports from applicants. If they see you’re heavily in debt, they may deem you too risky to take on as a tenant.
What if you fail to make your minimum payment on time?
Here are some of the consequences of not honouring your minimum payment deadline:
- Interest rate increase. Your card provider can raise the current interest rate you pay on purchases. Usually this occurs if you miss two payment deadlines within 12 months.
- Late fees. You may incur a late payment fee if you miss your payment deadline even by a few days.
- Credit score impairment. On-time payments are vital for a healthy credit score, so missing a deadline can cause it to drop, sometimes substantially. However, your payment typically must be late by more than 30 days to result in a downgrade.
- Loss of promotional offers. Your card issuer can rescind any promotional offers you previously qualified for, such as a temporary zero-percent interest rate.
- Card cancellation. Late payments elevate your riskiness as a borrower, so don’t be surprised if your card issuer abruptly chooses to shut down your account.
How to avoid the minimum payment trap
Ideally, you should pay off your entire balance each month. But that’s not always possible, as cash shortfalls and unexpected bills can stress your budget. Sometimes, you may have barely enough money to satisfy the minimum payment on your credit card.
However, you should strive to pay more than the minimum amount whenever you can. Paying just a little extra each month can help you reduce your interest charges, pay off your balance faster, and even boost your credit score.
If you find it too challenging to pay off your balance in one lump sum, consider making smaller payments, say every week. By doing so, you’ll also reduce your total interest expense since credit card interest accrues daily.
Another idea is to apply for a balance transfer credit card. These cards offer low or zero-interest introductory rates, typically lasting for 12 to 18 months. You can gain financial relief from interest charges during this time frame, allowing you to pay off your balance faster.
However, if your finances are in dire shape, you may need a helping hand to escape the minimum payment cycle. That’s where we come in!
At David Sklar & Associates, our team of Licensed Insolvency Trustees and Credit Counselors can review your situation and craft a personalized plan to get your finances back on track.
There are many debt relief options available at your disposal. We’ll help you explore each one in detail, so you can confidently choose the one that’s right for you.
Contact us today for a free, no-obligation consultation with one of our debt experts – you owe it to yourself!
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