Written by: Mike Senecal
Edited by: Austin Lang
Reviewed by: Jon McDonald
I won’t tell you that making the minimum payment amount required on all your loans is a ticket to Easy Street because it’s not.
A minimum payment is the smallest amount you’re required to pay regularly toward your loan or credit card balances to avoid penalties, late fees, delinquency, and eventual default.
It’s the minimum amount you need to pay — usually a combination of interest and principal — to maintain a positive credit history and at least an average credit score.
But stretching yourself so thin that all you can do is make the minimums to stay afloat? That’s not a recipe for future comfort and security.
Let’s explore the reality of minimum payments to understand how they fit within the credit landscape and how to manage your debt when minimum payments are a factor.
Common Types of Financing with Minimum Payments
We here at BadCredit.org know better than most how events beyond anyone’s control can send people spiraling into a financially precarious situation. All too often, the interest cost of your loan may be so high that paying the minimum doesn’t get you much of anywhere.
You want to protect yourself from falling into that situation. If you’re already there, you want to work your way out. A strategy of paying the minimum on certain debts can free up cash for other productive uses as part of an overall financial wellness plan.
Different credit and loan types have different structures, interest rates, and minimum payment stipulations. Understanding the distinctions helps you weigh the implications of taking on and managing various kinds of debt.
Credit Cards
Credit card debt is revolving, meaning account holders may carry a balance. They can pay it down monthly, but more debt is added as interest accumulates on the balance and they make additional purchases.
Interest is charged to the entire remaining balance every month, which can have huge implications depending on the balance and rate.
If you own a high-interest credit card, your interest rate might be so high that your minimum payment fails to reduce your balance significantly.
Then, you end up paying for the privilege of carrying a debt. Aside from the frustration of not seeing much movement in your statement, paying monthly interest to have credit card debt may make the next financial hurdle in your life harder to overcome.
Student Loans
Federal student loan borrowers typically pay a combination of interest and principal. Luckily for borrowers, structured repayment plans protect them from the worst that can happen with credit card debt.
Undergraduate borrowers on the standard plan pay the same monthly amount over 10 years. Borrowers who expect their income to increase significantly may choose a graduated plan with the same 10-year cycle but lower payments at the beginning and higher ones at the end. You can also choose an extended plan with fixed or graduated payments over a 25-year cycle.
Income-driven repayment plans are different because they calculate minimum payments as a percentage of discretionary income, meaning income above the federal poverty line. That line varies according to the individual’s household size and location. The popular SAVE plan caps monthly payments at 10% of discretionary income.
Income-driven repayment plans protect borrowers from falling into the kind of debt spirals that can happen as a result of credit card misuse. So do the many deferment, forbearance, and forgiveness programs available to those who demonstrate need.
Adjustable Rate Mortgages
Like a typical student loan, your average 30-year, fixed-rate mortgage is an amortized loan, meaning borrowers make regular minimum monthly payments of interest and principal. More goes toward interest in the early years because the loan balance is high. The interest portion becomes smaller as the balance decreases, and more goes toward paying down the principal.
Opting for an adjustable-rate mortgage changes the game, not necessarily to the advantage of the borrower. The appeal is the low interest rate at the beginning of the term. But the rate is set up to fluctuate according to an interest index and/or adjustment schedule.
The minimum monthly payment can increase significantly as a result. Families purchasing their forever homes may not want that. But adjustable-rate mortgages can actually be a good choice for those planning to sell or refinance before the rate has a chance to increase too much.
They can also work for new households that expect their income to increase. If you’re in the market for an adjustable-rate mortgage, let it be because you’re looking for an advantage, not for more house than you can afford.
Why It’s Important to Make Minimum Payments
Minimum payment thresholds for credit cards, student loans, and adjustable-rate mortgages are there to incentivize borrowers to pay down their loans. The consequences of incomplete payments extend beyond your relationship with your lender to your financial reputation as a whole.
Avoiding Late Fees and Penalties
Things start to happen as soon as your payment due date passes.
That’s when your creditor usually tags a late fee onto your balance. From that point, repaying your loan or credit card balance just gets more expensive.
It works differently depending on the financial product. Credit card holders incur late fees for failure to pay the minimum according to their billing statement. Those dates can seem arbitrary, especially for account holders doing business online.
Every card issuer has a unique system for grace periods and managing their limits. Cardholders who fail to make their minimums can also expect interest rate increases.
Late fees for student loans are typically around 6% of the payment amount. Paying below the minimum or going into default can cause borrowers to lose access to income-driven repayment plans and other options. Late fees for adjustable-rate mortgages can incur late fees, increase your overall debt burden, and make catching up on everything more complicated.
Protecting Your Credit Score
Your credit score is your calling card to the financial services industry, informing lenders about your past borrowing behavior to help them assess how much of their money to trust you with in the future.
Expect your score to decline if you don’t make the minimum payment for 30 days. That’s when creditors report your payment as late to the three major U.S. credit bureaus — Equifax, Experian, and TransUnion.
It’s hard to know how much your score will decrease after every subsequent failure to make your minimum payment because every credit history is unique.
Suffice it to say your score will continue to drop, perhaps even in ever greater amounts, as payment cycles pass.
Avoiding Default or Collections
One of the final consequences of your continued behavior (at least as far as the creditor is concerned) is a loan default.
That’s when your creditor gives up on your account by writing off your loan as a loss on their books. Not surprisingly, those actions trigger some reverberations throughout the financial system, all having to do with you.
Your credit score goes out the window — not literally, but in terms of another significant hit. By now, your score might have dropped by as much as 100 or 150 points or more, enough to put you in a territory you’d rather not inhabit.
Meanwhile, your lender will likely sell the debt associated with your loan to a collections agency.
Remember that creditors regard debts as revenue-generating assets. They sell portfolios of defaulted loans like yours, at a fraction of their original value, to agencies willing to hound at least some of those borrowers enough to earn back more than they paid.
How Lenders and Creditors Calculate Minimum Payments
Fortunately, lenders must state their terms in ways designed to assure transparency. That means they can’t try to trick you with misleading language or fine print. The Truth in Lending Act requires lenders to disclose the annual percentage rate, total finance charges, and payment terms of their products clearly and consistently.
It’s my opinion that every responsible borrower has the opportunity to assess the value proposition of any loan or credit card by understanding those terms in the context of their finances and performing a cost-benefit analysis.
Percentage of Balance Owed
Credit card issuers typically set the minimum payment around 1% to 3% of the total outstanding balance after a 28- to 31-day billing cycle. That includes the carryover balance, if any, along with new purchases, interest, and fees.
A no-interest grace period on new purchases usually extends from the billing cycle completion date to the payment due date — usually around 21 to 25 days — to accommodate those paying their balance in full. Interest on cash advances and carryover balances typically starts accruing immediately.
Keeping a grace period on new purchases requires paying your statement balance in full.
Things are more complex in the world of federal student loans, where the standard repayment plan determines a consistent amount of interest and principal owed each month. Minimum payments for various income-driven repayment plans, on the other hand, fluctuate annually as calculations change.
Likewise, minimum payments for adjustable-rate mortgages usually increase after an initial fixed-rate period.
Interest and Fees Included
Minimum payments include interest charges, fees, and additional costs, such as overdue amounts.
Think of interest charges as the price of your loan or credit card. Lenders and issuers agreed to give you some of its cash and let you pay it back over time. Why in the world would they not charge you for the privilege? So, they typically calculate interest repayment as part of the minimum payment due.
Meanwhile, late fees penalize not just missed payments but payments less than the minimum before the payment due date. Card issuers are also liable to charge you for exceeding your credit limit. Some loans include service fees and processing charges that become part of the minimum amount due if left unpaid.
Avoid negative amortization in loans, which is when your minimum payment doesn’t cover your interest.
Mortgage payments, including those for adjustable-rate mortgages, typically incorporate payments to an escrow account for paying annual property tax and insurance bills.
Particularly with certain adjustable-rate mortgages, negative amortization may occur, where your minimum payment doesn’t cover the total interest owed. Unpaid interest added to the principal balance increases the total amount owed in ever-escalating increments.
Fixed Minimum Payment
As we’ve discussed, amortized loans charge a fixed minimum payment according to a schedule. Along the way, borrowers pay a changing ratio of interest and premium until both reach zero within the specified time frame.
However, income changes may drive changes in minimum student loan payments, and adjustable-rate mortgages may change as a matter of course.
Understanding the impact of making minimum payments becomes harder when payback terms change over time.
The Impact of Only Paying the Minimum
By now, you realize we mean what we say when we recommend doing everything you can to stay out of a minimum-payment situation.
The costs of credit mount with time, so it pays to plan ahead and only take on debt you can manage.
You May Pay More in Interest Over Time
Stringing along your credit card payments by paying only the minimum means your lender gets to calculate your interest payments, month after month, from a larger balance than if you paid a larger amount.
Paying only the minimum leads to higher interest costs over time because the balance decreases as slowly as it possibly can without getting you in trouble.
Anything you pay above the minimum payment lowers that balance (after you’ve covered all your interest and fees, of course), so it decreases faster.
It Takes Longer to Pay Off Debt
To illustrate how credit card repayment scenarios diverge with different payment strategies, let’s calculate a couple of scenarios starting with a balance of $5,000 and an annual interest rate of 20%. For this example, we will also assume that you won’t make any purchases with the card.
In the first scenario, you make a minimum payment amount of 2% of the outstanding balance, which means a payment of $100 after the first month and a slightly lower payment every month thereafter. You pay a $200 monthly amount in the second scenario. Here’s how the first two months play out:
| Minimum payment | $200 fixed payment | |
|---|---|---|
| Month 1 payment | $100 | $200 |
| Month 1 interest charged | $83.50 | $83.50 |
| Month 1 remaining balance | $4,983.50 | $4,883.50 |
| Month 2 payment | $99.67 | $200 |
| Month 2 interest charged | $83.24 | $81.57 |
| Month 2 remaining balance | $4,967.07 | $4,765.07 |
Believe it or not, that modest difference of slightly more than $200 in the remaining balances after the second month can grow into a massive difference in your balance over time because the numbers diverge more and more.
By paying only the minimum, you’d need more than 20 years to pay off the credit card (assuming you didn’t use it again), and the total interest you’d pay could exceed $5,000 or more.
In contrast, if you committed to paying a solid $200 every month, you’d pay off the loan in about 33 months — less than three years. Furthermore, you’d pay only about $1,370 in interest for a savings of more than $3,500.
You Risk Accumulating More Debt
Clearing a debt means more money to spend on other things, including paying down other debts. Sticking to minimum payments while continuing to use credit can result in growing balances and a deeper overall financial obligation.
Common sense financial wellness management is all about tradeoffs and priorities. Any financial counselor worth your time will have a plan for you to pay more than the minimum in mind to achieve mastery over your finances.
But the choice is up to you.
Strategies to Manage Minimum Payments
I’ve already stressed that no responsible financial wellness advisor would recommend paying less than the minimum amount owed on any loan unless necessary.
In that event, work with a counselor, such as a free financial counselor from a nonprofit credit counseling agency, to determine your payment strategy. And communicate with your creditors if you plan to enter delinquency, default, or bankruptcy. They may be surprisingly open to discussion.
It’s much better to follow common-sense strategies to keep yourself from falling into that situation.
Budgeting for Payments
The best course when finding yourself face-to-face with a minimum payment situation is to create a budget — if you haven’t already.
Your budget should prioritize debt reduction and more-than-the-minimum payments.
There’s no shortage of budgeting information online. Every financial counselor you run into will have a budgeting recommendation. My advice is to keep it simple, especially when you are starting out.
Budgeting apps can be excellent at what they do. However, when my parents started their marriage in the 1960s, they used the envelope system, distributing cash from my father’s modest paycheck to different uses.
The best budgeting system for you is the one you will use.
Pay More Than the Minimum
Whenever possible, pay more than the minimum to reduce your debt faster and save on interest costs.
Paying a credit card company for the privilege of carrying debt seems wrong on so many levels that it’s hard for me to believe I once lived that way.
Part of your financial wellness recovery plan should include increasing payments strategically to more than the minimum to bring some debts to a close, while marshaling resources for others.
Concentrate on paying what you owe and transitioning to a debt-free lifestyle.
Setting Up Autopay
Automate your minimum payments to ensure you never miss one and avoid unnecessary penalties.
Part of the problem for many is bad decision-making around money management, which consigns them to pay more than they owe.
Setting up auto-deposit and autopay can reduce the chance of financial mismanagement through guesswork.
Be sure you account for your automatic payments in your budget to avoid even more significant problems than the ones you’re trying to solve.
Debt Payoff Methods That Leverage Minimum Payments
Financial websites and advisors typically advise you to make more than the minimum payments, but there are two popular exceptions.
These are when using the debt snowball or the debt avalanche methods to pay off your debt over time.
The snowball method involves paying off your smallest debt first with higher-than-minimum payments (while actually paying the minimums on other cards) and work your way up until all of your debt is paid.
With the avalanche method, you tackle the highest-interest debt first and work your way down. This also involves making the minimum payments on your other credit cards while focusing on one.
The avalanche method prioritizes interest savings and can save more in the long run. But the snowball method may be for you if small successes motivate you to achieve larger ones.
Minimum Payments Can Lead to More Debt Over Time
At the beginning of this article, I said making only the minimum payment required on your credit cards — and some loans — can put you on the road to financial hardship. The best use for your money is always to pay down your debt.
We’ve pointed out minimum-payment debt hazards like credit cards, student loans, and adjustable-rate mortgages and described the consequences of making less than your minimum. You know the math behind how lenders calculate minimum payments.
And you know what to do to keep yourself from falling into a situation you can’t get out of. Incorporating a few money management basics can prevent excess debt or make paying it down easier.
