Credit card debt is a lot like body weight: It adds up when you’re not paying attention and can be hard to get rid of. Once credit card debt has crept up, your monthly budget may feel too tight to pay more than the monthly minimum payment.

There is no industry-wide interest rate or even an agreed-upon way to calculate the minimum payment. Each credit card company sets its rate, and you’d better believe they design minimum payments in a way that benefits their bottom line. According to data from research firm R.K. Hammer, credit card companies hauled in $176 billion in 2020, despite the global pandemic.

One way credit card companies tilt things in their favor is to trap consumers in an endless cycle of making payments on high-interest debt. The average interest rate on a credit card is 16.13%, which makes paying down the debt much more challenging. Credit card companies love it when consumers make only the minimum payment because it earns them more money.

If you’re in the habit of making a minimum credit card payment each month, here’s what happens.

You pay more in interest

Let’s say you routinely use a credit card charging an interest rate of 16%. A nearby electronics store is going out of business, and you snag a 65-inch TV that usually sells for $3,500 for $2,700. If you pay the balance in full before the next billing cycle, you get a real bargain – a sales price and no interest payment.

Imagine that you don’t feel comfortable paying the balance in full, so you make a $63 payment each month until the card is paid off. If you never add another charge to the card, it will take five years and four months to pay in full, including $1,330 in interest payments. Altogether you spend $4,030 for the TV, and by the time you’re done paying for it, it’s over five years old, and newer models have been released.

Would you have agreed to purchase the TV that day in the electronics store if you’d known it was going to cost you more than $4,000?

Your credit score could be impacted

A FICO® Score is a three-digit number based on information gathered from your credit reports. A score can range from 300 to 850, with a higher score indicating you’ve managed your financial obligations well in the past. While there are other scoring systems in place, FICO is the most commonly used in consumer lending. FICO is quite secretive regarding the precise manner in which they arrive at a score, but roughly speaking, it breaks down like this:

• Payment history accounts for 35%. Your payment history represents how faithfully you have paid bills each month.

• Amounts owed accounts for 30%. This category relates to how much you owe in relation to how much credit you have available. The less you owe, the better. For example, if you have $10,000 credit available across several credit cards, your FICO® Score would benefit more from you owing $1,000 (only 10% of your total available credit) than $8,000 (using 80% of your total available credit).

• Length of credit history makes up 15% of your score. In short, the longer you’ve had (and managed) credit, the more comfortable lenders are about your ability to handle any debt they finance.

• New credit is worth 10% of your total score. This is where creditors look to see how often you’ve recently applied for credit and how many new financial obligations you’ve taken on.

• Credit mix makes up the final 10%. Credit mix refers to the types of credit you carry. For example, do you have three car payments but no other types of credit? Or do you have five credit cards and nothing else? Ideally, your credit mix is such that creditors can see how you manage several different types.

Now, back to that credit card you’re making the minimum payment on each month. As long as you hold on to the card and pay at least the minimum, both “length of credit history” and “payment history” benefit.

Where you could find yourself in trouble is with the “amounts owed” category. The longer it takes you to pay a debt off, the longer you’re utilizing a chunk of your available credit. If that’s the only debt you have, it’s probably not a problem. However, if you routinely make charges to credit cards and make the minimum payment on each, it’s safe to expect it to ding your overall credit score.

Making only the minimum payment sets a trap

Once you get in the habit of making minimum payments only, it can be hard to change. For one thing, interest on the debt eats away at the money you could have otherwise kept in your bank account and used to pay the debt off in full. And if your amount of credit owed does ding your credit score, it can be tough to convince your credit card company to lower your interest rate or qualify for another card with a 0% APR.

Your best bet is to always pay credit cards off as quickly as possible. Can’t do it today? That’s okay. Using the same scenario as we used earlier, let’s imagine that you pay an extra $50 on top of the $63 minimum payment each month, for a total monthly payment of $113. Instead of paying the card off in five years and four months, you’d pay it off in two years and five months. Rather than paying $1,330 in interest, you’d spend $573.

Winston Churchill once said, “Perfect is the enemy of progress.” In other words, you don’t have to be perfect; just keep moving in the right direction.

The post Here’s What Happens When You Make the Minimum Credit Card Payment Only appeared first on The Motley Fool

Original source: The Motley Fool