One of the first steps to getting your finances back on track is reducing your credit card debt by paying off your credit cards. However, many consumers only make the minimum payment on their card each month.
Joe Parsons, loan originator at PFS Funding says that when consumers put down their credit card to pay for a meal out or impulse purchase buy, they don't feel as though they are spending real money.
"You got something that you wanted, but didn’t feel the pain of actually pulling money at your wallet," Parson says. "When the credit card bill comes, you are surprised at the amount you spent, but it still seems like an abstract number. Instead of transferring money to pay off the account or cutting back spending, the minimum payment amount looks very attractive and many people will then just pay that amount."
But paying the minimum amount due can have a serious impact on your finances, credit score and ability to get additional credit in the future.
Here are three reasons why paying the minimum amount due is not a smart financial move:
1. Negative Impact to Your Credit Score
One of the factors used to calculate your credit score is the percentage of your available credit that you have used. According to MyFico.com, 30 percent of your credit score is calculated based on the amount owed. By paying only the minimum, you often will owe more in interest for the month that you pay, which will increase your utilization percentage even if you do not use the card.
Kevin Gallegos, vice president of Phoenix operations for Freedom Financial Network, LLC says that if you have a credit card with a $10,000 limit and you owe $3,500 then you have 35 percent utilization, which will reduce your score. "Having over 50 percent utilization will have a definite negative impact on a credit score, and a maxed-out card will very negatively impact the score," says Gallegos. "The lower your percentage utilization percentage (while still using some credit, and paying off the balance in full each month), the better your credit score."
2. Extended Time to Become Debt Free
If you only pay the minimum amount each month, even if you do not make additional charges, it will take an extended time to pay off the card. If your utilization score is affecting your credit score, then this length of time will cost you additional money in higher interest for other credit. "Paying the minimum of $300 on a card with a rate of 18 percent and a balance of $10,000, it will take 47 months to pay off the balance assuming the user stops using it altogether," says Parsons. You can also lose other opportunities where credit score is factored, including employment or rental application acceptance.
3. Paying High Amount of Interest
If you pay off your credit card by only paying the minimum payment each month, you will have paid a lot more total costs than if you had made larger payments throughout the life of the debt. Gallegos says that if you had a $10,000 credit card debt with a 19.9 percent interest rate, a minimum payment of 3 percent of the monthly balance would be $300. "Paying only the minimum (which will decrease over time as your balance decreases, with a floor in this example of $50) will cost $21,080 and take 15 years to pay off," says Gallegos. "Alternatively, a constant payment of $500 per month would cost a total of only $12,250 – and you would become debt-free in just two years. You would save almost $9,000 and cut off 13 years of payments." To determine how much paying the minimum payment will cost you in additional interest, calculate different payment scenarios and see how long, and how much, you really want to pay.
"Few investments can top the rate of return; paying off credit card debt at typical interest rates effectively makes an investment that returns 20 percent or more per year," says Gallegos.