When the bills come in, do you pay the minimum amount due for each, and think you're being financially responsible as long as you make those payments on time?
Unfortunately, it's not that simple. Those minimum payments are actually one of the insidious ways creditors keep you in debt if you let them. "But they want to get paid back fast, don't they?" you ask. No, they do not. They want to keep making money off the interest you're paying them for the longest time period possible.
If it's the best you can do, making minimum payments is still better than not paying anything. That could cause your case to get sent to a collection agency, which is much worse than dealing directly with your creditors to work out a better repayment plan. But beyond that, making only minimum payments ultimately hurts you.
Read on to learn about how those minimum payments get calculated, the effects they can have on the total amount owed and on your credit score, and ways you can pay more than the minimum.
Minimum Payments Are Designed to Keep You in Debt
The minimum payment due on your monthly statement represents the lowest amount the bank or lender will accept on your credit card, car loan, student loan, personal loan, or mortgage loan balance. Do the math on a few of your bills: Most minimum payments equal around 3% to 5% of the total amount owed.
And thank goodness for current federal guidance! It stipulates that the minimum amount due must include the interest plus any fees, as well as a small portion of the principal balance.
Before that federal guidance went into effect, minimum payments did not have to cover all the fees and interest, or any of the principal balance. So, these unpaid fees and interest amounts would keep adding to your monthly balance, causing it to rise continually — a problem called negative amortization.
Paying the minimum may not send you into the hole anymore, but it's still difficult to dig yourself out of debt when you're mostly paying interest and fees.
Paying the Minimum Makes Debt Cost More
When you only pay the minimum, you are paying so little toward the principal balance every month, you're actually increasing the amount of time you're in debt. This increases the time you'll keep making interest payments, which causes the total amount you're paying to grow.
Using a simple student loan calculator, just look at the difference in interest paid on a $40,000 loan at 6.8% interest (the rate of a Stafford loan) when the term is 8 years, compared to 10 years:
8 year loan: Payments are $546 per month and $52,497 total (or $12,497 more than the principal amount).
10 year loan: Payments are $465 per month and $55,796 total (or $15,796 more than the principal amount).
So the loan with the lower monthly payments will end up costing you $3,299 more over just two years.
The longer you take to pay off any kind of debt, the longer lenders are charging you interest and laughing all the way to the bank. This is especially true for long-term debt, like student loans and mortgages.
In fact, there's an interesting warning in large, black-and-white letters on Capital One credit card statements: "If you make only the minimum payment each period, you will pay more in interest and it will take you longer to pay off your balance."
Paying the Minimum Destroys Your Credit
Paying your bills on time represents a big portion of your FICO credit score. That's why you might think you're protecting yourself by making those minimum payments each month. But another big factor in your credit score is your amounts owed, and your credit utilization plays a big part in that. Credit score models analyze how much credit you have used, compared to how much credit you've been offered, and they like to see that ratio below 10%.
Just paying the minimum balance on your credit cards keeps your credit utilization high, which lowers your credit score.
Poor Credit Impacts an Auto Loan
Experian Automotive's 2016 research into the auto-lending industry found that borrowers with a good, or prime, credit score (661-780) paid an average interest rate for a new car of 3.6%, while those with nonprime credit scores (601-660) paid 6.42%. The research also found that nonprime and subprime borrowers (with even worse credit scores) were more likely to take long-term loans than prime or super prime borrowers.
For example, consider a $25,000 car loan. Let's assume that if you have a lower credit score, you'll also want to make lower monthly payments over a longer period of time. Here's how a lower credit score can hurt your interest rates and increase the overall amount you'll pay back:
Prime credit: A $25,000 car loan at 3.6% interest results in payments of $456 per month for 60 months, for a total of $27,355 paid (or $2,355 more than the loan amount).
Nonprime credit: A $25,000 car loan at 6.42% interest results in payments of $419 per month for 72 months, and a total of $30,189 paid (or $5,189 more than the loan amount).
That's a big difference, right?
Those with super prime credit scores (781-850) pay even less, while those with subprime credit scores (501-600) and deep subprime credit scores (300-500) can expect significantly higher interest rates — up to about 14% for new cars and 20% for used cars, according to Experian.
How to Pay More Than the Minimum
The common advice is to never carry a balance on a credit card and always pay off balances before their due dates, completely avoiding minimum payments. If that's not possible, throw any amount more than the minimum toward your balance to chop it down faster.
Consider making bimonthly payments for mortgage loans, for an automatic extra payment every year that will shave thousands off your overall amount paid over 30 years.
If you get a tax refund (and already have some emergency savings), put it toward your high-interest student loan debt or high-interest credit card debt to reduce your balances by a large chunk. Or consider the debt snowball method.
The sooner you pay off any balance, the less you'll pay overall, the better credit you'll have, and the better rates you'll get for borrowing money in the future.
Readers, how do you handle debt payments? Let us know in the comments below!