Credit Card Payment Allocation Explained
You can typically use your credit card for a variety of transactions. In addition to purchases, your card can come in handy for transferring balances or for taking out a cash advance. Your credit card statement presents an overview of your credit card balance, which combines different transactions together for simplicity. However, when you're paying toward your credit card balance each month, your monthly credit card payments could get divided up among the balances or applied to just one balance, depending on how much you pay.
Splitting up your credit card payment can affect how you pay off your credit card balance. You may think you're paying off your balance transfer, but your payments are actually being applied to your purchases balance.
Different Interest Rates
You might have balances with different interest rates if you've made different types of transactions on your credit card, e.g. purchases, balance transfers, and cash advances. Your balances might also have different interest rates if you triggered the penalty rate by being more than 60 days delinquent on your payment.
If you've triggered the penalty rate, the interest rate will go back to normal on your existing balance after six timely payments, but new purchases may still be charged the penalty rate.
Payments Split Between Balances
If you have balances with different interest rates, you want your monthly credit card payments to be allocated fully, or at least mostly, toward the balance with the highest interest rate, e.g. a cash advance. That way, you can get rid of the most expensive balance first. However, credit card issuers may prefer to reduce the lowest interest rate balance first, so they receive as much interest as possible on the higher rate balance.
Prior to the Credit CARD Act taking effect in February 2010, credit card issuers could legally allocate payments at their discretion. They would often apply these payments to the balance with the lowest interest rate, which meant higher interest rate balances would decrease slowly and incur more interest. As a result, many credit card holders were paying more interest, taking longer to pay off their balances, and not receiving the benefit of a low-interest rate promotion.
Payment allocation rules only apply to consumer credit cards, not business credit cards. If you have a business credit card with balances at different interest rates, the credit card issuer can decide how to split your payment among the balances—if the payment is split at all.
How Creditors Should Split Payments
Creditors must apply any credit card payment above the minimum to balances with the highest interest rate. The minimum payment, however, can be (and typically is) applied to the balance with the lowest interest rate, which will usually include balances with a promotional interest rate.
For instance, let's say you have a credit card with a $1,000 balance: $500 of the balance are purchases you made at 20% APR and the other $500 is a balance transfer at 10% APR. Let's also say your minimum payment is $25. If you make a $100 payment, the first $25 will be applied to the balance transfer and the remaining $75 would be applied to the more expensive purchases balance.
When you have balances with different interest rates, you have to pay more than the minimum to reduce your higher rate balance. If you only pay the minimum, your higher rate balance might not decrease at all. In fact, when finance charges are added, that particular balance might go up.
In our example above, if you only made the minimum payment of $25, nothing would be applied to the purchases balance and that portion of your overall balance wouldn't budge a bit.
The payment allocation rule doesn't specify how credit card issuers should split up payments when purchases and balance transfer balances have the same interest rate.
You can avoid payment allocation confusion by not mixing balances with different interest rates on your credit card, especially if you can't afford to pay more than the minimum payment. That means avoiding balance transfers to credit cards that already have a purchases balance or making purchases on a credit card with a balance transfer. Likewise, avoid taking a cash advance on a credit card that already has a balance or making purchases/transferring balances to credit cards with a cash advance balance.