How minimum payments keep you stuck in debt (and what to do about it)

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How minimum payments keep you stuck in debt (and what to do about it)

Doing the bare minimum doesn’t get you far in life or at work, and it also won’t serve you well when it comes to your credit card bill.

Each time you receive your monthly statement, there’s the option to make a minimum payment. This is your card company’s way of mandating you to pay some money towards your balance. They do this both because they want to be paid at least something and to keep you from falling completely into debt.

Yet it’s also their way of ensuring you stay in debt, since the longer you take to pay off your credit card, the more they can charge you in interest and fees. It can cost you a lot of money, so here’s what you can do about it:

You’ll be paying off your credit card until infinity

Your minimum payment will usually be a fixed amount set by your credit card provider (somewhere around $20 or $25), or depending on the card, a small percentage of your balance, usually 2 to 4 percent.

Paying just that small amount each month can give you the illusion that you’re making a dent in your debt, but the truth is, you’re not. Even if your card has the lowest interest rate on the planet, you’ll still never significantly reduce your credit card balance if you make just the minimum payment -- at least not enough to keep up with your spending.

Say you have a $1,000 credit card balance and you make the $25 minimum payment, bringing down your total to $975. Without taking interest or future spending into account, it would take you over three years to reach a zero balance at that rate. And that’s if you never charge another cent on the card. The more money you spend, the longer you extend your overall repayment period with just the minimum payment in effect.

You’ll be stuck paying off interest, not your principal

Making matters worse, paying only the minimum on your credit card means most of your money will end up going towards interest, not your balance.

Credit card interest behaves the same way it does for a mortgage, a car loan, or a student loan: it accrues and compounds on top of itself each billing cycle, and the longer you leave it unpaid, the more interest builds, and the harder it becomes to pay it all off.

Say at the end of the billing cycle you’ve got that same $1,000 credit card balance, and your interest rate is 16 percent. Unless you pay your bill in full where interest has no chance to take effect, your APR will tack on an extra $13 in the first month. That means most of your minimum payment goes towards paying the interest, the rest to your principal balance. So, after that first billing cycle, your total with interest is $1,013, and your minimum payment of $25 reduces your balance to $988 -- only $12 less than your original balance before interest comes into play.

Now, figure that you spend nothing else on the card the next month. Your current $988 balance accrues more interest based on the 16% APR, totaling another $13 in interest and pushing your balance up to $1,001. The interest still eats up most of your minimum payment, leaving your balance at a near constant standstill. As the balance keeps revolving, your interest continues to grow.

If instead your minimum monthly payment is calculated as a percentage of your total balance (say 2 to 4 percent), then the money goes an even shorter distance financially, since it’s deliberately devised not to outpace the interest compounding on your bill. That means your credit card company sets its minimum payment rates just right to make a profit from you.

You may be able to avoid penalty interest by making the minimum payment, but your standard interest rate still takes hold of your balance. Even if you stop using the card altogether you would need to pay more than the minimum to make any headway with aggressive interest rates. That’s not taking into account the possibility of your credit card provider raising their rates or fees to the point that a minimum payment won’t begin to cover them before you’ve even touched your balance.

Your credit score may suffer

Your credit utilization -- how much of your available credit you utilize -- is an important part of determining your credit score. Limiting your credit usage to 30 percent of your credit limit is the recommended ratio to reach; anything higher can harm your score and indicate to credit reporting agencies that you’re relying too much on credit to get by.

If you’ve spent half or more of your credit limit, your credit score becomes vulnerable. And when your credit score suffers, your ability to acquire other forms of credit weakens.

Minimum payments chip away at your balance in the short term, but in the long run, it’s not enough to keep up with compounding interest, which can push your total debt past the recommended ratio of 30 percent. You don’t even need to spend too much of your available credit; your card’s interest will end up doing that for you. It still counts as reportable credit activity that can harm your credit -- namely, that you’re carrying a balance indefinitely and doing very little to pay it off.

If you’re not making large enough credit card payments to reduce your debt, your balance will keep getting higher, as your credit score keeps lowering.

Maximizing minimum payments

Minimum payments are useful from time to time, like if you’re truly strapped for cash a couple of months out of the year and can only afford to put down a small amount just to stay current and avoid penalty interest. One way to start increasing your payments up from the minimum is to cut your costs, free up cash, and apply them towards your balance. Reducing your credit card spending, negotiating for better insurance rates or with your creditors, or getting a balance transfer are just a few options to save money that can go towards your credit card balance.

If you have a manageable amount of debt that you could you could realistically pay off in a year, you may want to consider transferring your balance to a new credit card that will offer you 0% on transfers for a fixed period—often a year or 18 months. Just make sure to pay off your balance before the promotional period ends, or you could be stuck right back where you started, battling big interest charges with your monthly payments.

Sometimes paying more than the minimum on your credit card is a budgeting issue. Sometimes it’s a matter of being more disciplined. Whatever the reason, there’s no reason to stay mired in mounting interest when you’re doing your best to pay off your balance. By knowing the consequences of an unpaid balance, and which steps to take to rectify the problem, you’ll be able to pay your bill in full, on time, for a zero balance each month -- and zero debt.