Whether your financial goals are as simple as building a small emergency fund or as complex as savings and investments for retirement, few things can derail your plan faster than debt. That is why most experts and financial planners suggest prioritizing debt repayment first, before many other goals, and recommend paying down that debt as fast as possible.
But not all debt is created equal, and a good debt repayment plan will keep these differences in mind. Loans with a low interest rate (around 7% and below) such as mortgages and federal student loans have a built-in pay-off date. You can treat these like any other monthly bill: Even if you make only the minimum payments on this type of debt, you will eventually pay it off.
This is not the case with higher-interest unsecured debt such as credit cards. These lenders use a fairly straightforward system to calculate your minimum payment, but remember that this is a system that benefits the credit card company – not the consumer.
What happens if I pay only the minimum on my credit card debt?
- Slow payoff or no payoff
Credit card companies typically set monthly payments anywhere between 1% and 3% of the total balance. According to recent data, the average interest rate on credits cards is 18.61%, which is charged to that same balance. What this means is that, by paying only the minimum amount due, not only do you get no closer to a pay-off date, your debt can actually grow larger because of new charges and interest. Even though you are making consistent monthly payments, you are on a proverbial hamster wheel of debt that you can never get off.
- Lower credit score
Making only minimum payments can have other negative effects as well, including lowering your credit score. While making consistent payments on debt can help you maintain good credit, to some degree, credit bureaus also look at something called “debt ratio” when calculating your credit score.
his is the percentage of your possible debt you are currently using. In other words, if you have a credit card limit of $10,000, and you owe $1,000, then your debt ratio is 10%. Anything above a 30% debt ratio can lower your credit score significantly. Maxed out credit cards are not only a weight around the neck of your budget – they are also a weight around the neck of your FICO score.
Is it ever okay to pay only the minimum on my credit card debt?
We do not live in a perfect world, and even the best laid financial plans often have to be put aside for a time due to unexpected circumstances. While it is not recommended to regularly make only the minimum payment, there are a few times when it is okay.
- If you are on an aggressive debt repayment plan, and employing the snowball method to pay off multiple credit cards, it is okay to make minimum payments on every card other than the one you are actively trying to pay off.
- If you have a very low-interest card with an established date that it will be paid off. (Any debt with an interest rate higher than 7% should be handled with priority and tackled with more aggressive pay-off tactics.)
- Temporarily (read: no more than one or two months!) while concentrating on other financial goals.
- In rare emergencies when an unexpected expense exceeds your emergency fund.
Options to help maximize credit card debt repayment
We all know that it is best to pay off credit card bills entirely at the end of each month; that is a financial goal we should all aspire to. But that may not be realistic for your circumstances today. That does not mean there is nothing you can do. In fact, there are a couple of ways to make major headway with only minor adjustments.
- Pay twice the amount of the minimum payment. Doubling the minimum payment does more than just cut your pay-off time in half. Because of the significant savings in interest charges, it can actually reduce your payoff time by up to two-thirds.
- Make the minimum payment, but make it twice a month. If you aren’t able to swing a double payment all at once, break it up into two payments – or whatever schedule most closely aligns with your paycheck. You get the benefit of a double payment, but on a budget-friendly schedule.
- Pay 10% of the debt amount. This is a fairly aggressive payoff tactic, but one that can make major money moves quickly.
- Pay just an extra $10 or $15 toward each debt. If none of the other options are within your budget or ability, at least add the extra on the top of your minimum payment. These small amounts really do add up over time and can help get you moving in a positive financial direction.
Another helpful hint is to read the Minimum Payment Warning on the back of your credit card statement. This is where you will find the exact amount of time it will take to pay off your specific debt if you only make minimum payments, along with alternate payment options and ideas.
If you find yourself in the minimum payment pitfall and are unsure where to begin, call one of our friendly team members at DebtGuru.com. We can help you find ways to get off the hamster wheel and pay off your debt for good.