Yes, that “minimum payment due” box on your credit card statement looks so enticing. Pay a small amount, and you’re off the hook — for a month, anyway.
But as the nearly 45% of Americans who carry a balance every month know, that rotating charge usually comes back to bite you. According to the credit-card comparison site CreditCards.com, a cardholder who owes $16,000 (the average amount of debt per household) will end up shelling out an additional $11,000 in total interest by paying only the minimum each month.
Credit card companies prefer you maintain a balance on your cards, of course, because they make their money charging you fees and interest. The higher your card’s interest rate, the more income your card balance generates.
Negative Effects of Debt
However, credit card issuers don’t intend for you to use your entire credit limit. If you do start charging high enough to reach that amount, you’ll kick off a bad chain reaction of events, including:
A drop in your credit score. Thirty percent of your credit score is based on how much of your available credit you’re using. This ratio of credit card balances to credit limits is known as your credit utilization, so the higher that ratio is — meaning the closer you are to your credit limit – the more your credit score takes a hit. Maxing out one credit card is bad for your credit score, maxing out all of them is a disaster.
Lenders won’t like you. Whether you apply for a car loan or a mortgage, the lender wants to see how much of your available credit you’re using. If your credit card balances are too high, banks assume you have more debt than you can handle, and will put a big “denied” stamp on your application.
The risk of going over your credit limit. Even if you think you’re safely below your credit limit, you could still end up going over once finance charges are applied to your balance. If your balance does exceed the magic number, it can be difficult to go back because you’ll be charged an over-limit fee each month your balance is over the line.
Triggering the default rate. Credit card companies have the right to raise your card interest rate if you default on your credit card terms by maxing out your credit card. The default rate is the highest interest your card company can charge and, it’s typically a minimum of 30%.
A balance you may never be able to repay. A maxed-out credit card, with a default rate on top of that, could take years to pay, especially if you only pay the minimum. Even though you want to pay the balance in full, parting with that much cash may be hard to do by the time the payment due date rolls around.
So that those horrific events don’t happen to you, it’s wise to keep a low to no balance on your credit card. Having a balance below 10% of your credit limit won’t wreak havoc on your credit score, and it’s acceptable to lenders.
Debt Elimination Plan
And, of course, making monthly payments above the minimum is important; according to credit-scoring agency FICO, your payment history counts for 35 percent of your credit score.
Ultimately, you want to be one of the 54 percent of Americans who pay off their credit cards every month. But until then, ridding yourself of your current balance should be your top financial priority.
“You need an action plan to help you work at reducing and eventually eliminating what you owe,” says Gail Cunningham, a spokesperson for the nonprofit National Foundation for Credit Counseling.
Here’s how to put that pay-down plan into place:
Target just one card first.
If you’re carrying balances on multiple cards, it’s a long slog to wipe out all those debts. But there are three methods you can choose from to do so.
To give yourself a boost of instant gratification, put as much money as you can toward the card with the lowest balance first. Do this even if you need to pay only the minimum on your other cards in the meantime.
If you want to boost your credit score, then tackle the card with the highest utilization rate (figure that out by dividing your credit card balance by the card’s limit). Bringing the utilization rate down just 20% could significantly increase your score.
Or, if you want to pay less in interest overall, then pay off the card with the highest interest rate first.
Cancel your credit cards – but not all at once.
Each time you close a credit card account, it temporarily lowers your credit score, so avoid canceling more than one card in a nine-month period. The longer your credit accounts have been open, the higher your credit score.
But, ultimately, having the highest available credit line with the fewest number of cards is the best position to be in.
Transfer your balance – cautiously.
It’s tempting to move a balance from a card with a high interest rate to a card with a much lower one because you can end up saving hundreds of dollars a year.
However, you should only transfer a balance if you’re committed to paying off the debt within the introductory low -rate window, typically 12 to 18 months, and to making monthly payments on time. Otherwise, your rate could skyrocket, possibly ending up higher than the one you just got rid of.
Try not to make any new purchases with the card – the low interest rate often doesn’t apply to them. Also, know that you may be charged a balance-transfer fee, which is usually about 3% to 4% of the total amount you transfer over.
If you must make minimum payments, do it twice a month.
Card issuers typically charge interest on a daily basis, so the sooner you make a payment, the faster your average daily balance is reduced – and that translates into less interest that you’ll ultimately pay.
If you’re on a tight budget, go ahead and pay the minimum due each month, but try to make the same payment again two weeks later. Keep putting that twice-monthly minimum payment on your To-Do list until your debt is paid off.
To put it in perspective, say you charged $2,000 on a card with a 17% interest rate. If you make only the minimum monthly payment, which is about 2% of the balance, it will take more than 21 years to pay it off. But if you make an additional payment two weeks later, you’ll be debt-free in less than three years.
Quite a difference, right?
The Bottom Line
Because maintaining a positive payment history is critical to a high credit score, pay off your cards monthly. Keeping that balance down to a big fat zero translates into a glowing credit report.