Making only allowable minimum payments towards credit card balances is a certain way to prolong the debt and pay far more than necessary in interest. The Credit Card Act of 2010 forced credit card companies to provide clear information on customer statements to disclose how long it would take to clear a balance making only minimum payments. Card holders can also find information on their statements showing the calculation the card company uses to determine the amount.
Minimum payments are subject to monthly changes. A shift in the variable interest rate, a move to a penalty rate, and the addition of late payment fees, cash advance fees and other allowable fees will all cause the minimum payment to change. However, until 2003 the credit card companies primarily set a fixed minimum payment which could be smaller than even the monthly interest incurred, leading to negative amortization as the balance could effectively rise each month even if no additional transactions were made on the card.
In 2003 the Federal Reserve (page 3/6) examined this practice and determined that in the future it expected “lenders to require minimum payments that will amortize the current balance over a reasonable period of time, consistent with the unsecured, consumer-oriented nature of the underlying debt and the borrower’s documented creditworthiness.” Its aim was to put an end to “Prolonged negative amortization, inappropriate fees, and other practices that inordinately compound or protract consumer debt”.
The changes that were introduced meant that the credit card companies were obliged to calculate the minimum payment as a percentage of the outstanding balance, plus the monthly interest and any fees. Typically the card companies set their own percentage level of the balance, which can be as low as one percent but may be as high as five percent.
The calculation used takes the credit issuers percentage of the balance which is expressed on the monthly card statement, and multiplies it by the balance. This gives the minimum monthly payment as a percentage figure of the balance. Next the annual percentage rate is taken and divided by 12, to give the monthly percentage rate. This figure is then multiplied by the balance to give the monthly interest due. This figure is added to the first figure, plus any fees, to thus determine the monthly minimum payment.
Assuming an outstanding balance of $2,000, the card company’s percentage of the balance being 2%, and an APR of 16%, the calculation would appear as thus:
$2,000 x 2 % = $40.00
$2,000 x 1.3333 = $26.66
$40.00 + 26.66 = minimum payment plus any fees.
Based on this calculation the outstanding balance of $2,000 is reduced by $40 to $1,960 and the interest of $26.66 is paid rather than added to the balance. This allows the cardholder who only makes minimum payments to see the balance decrease month on month, assuming no further transactions are added to increase the balance. As the calculation shows the balance will reduce very slowly.
Card holders now have access to this information on their statement or can utilize an online minimum payment calculator which will show how long the balance will take to pay off if only minimum payments are made. If the cardholder can only afford to make minimum payments and no more it is advisable to contact the credit card company and request an interest rate reduction based on financial hardship.