One of the most attractive things about using a credit card is that you have the convenience of paying just a small amount of your balance each month until the balance is completely repaid. While this can make items more affordable at the time of purchase, it is easy to be tempted to purchase more than you can realistically pay for.
Minimum payments make it appear easier to afford something you normally couldn't. It typically costs much more in the long run than if you made payments in increments of more than the minimum required. There are many reasons to pay more than the minimum; avoiding compounding interest might be the top reason to do so.
Interest has a compounding effect, which can cause the balance to rise quickly. Higher credit scores depend on continuous low balances and timely payments keep your score up when you run a balance. Following these guidelines over time increases the confidence lenders have in you, which raises your score and your credit limit. This allows you to finance larger items, such as a vehicle or home.
You'll Save Money On Interest.
When you make minimum payments, you ultimately pay more in interest charges than when you pay your balance with bigger payments. You could save hundreds, or even thousands of dollars in interest just by raising your monthly credit card payment.
For example, if you have a $2,000 balance, on a card with a 14% annual percentage rate (APR), paying the minimum of $43.33 a month will cost $1,833 in interest charges and take over 14 years to pay off. If you instead pay $100 a month and make no future charges, you'll only pay $291 in interest, saving more than $1,500 in interest.
Pay off the Balance While Enjoying the Purchase
Making the minimum payment not only costs more money in the long run, but it will also take you longer to completely pay off your balance.
In the previous example, it would take more than 14 years to pay off a $2,000 credit card balance (at 14% APR) by making minimum payments. There are not many consumer items or services that last for 14 years. Suppose that $2,000 went towards a new television. If the television only lasted 10 years, you would still be paying it while looking for another one.
On the other hand, sending $100 a month consistently would allow you to pay the balance in just under two years. (Again, assuming you make no future charges on the card and your APR doesn't change).
Paying your balance sooner also positively affects your credit score, giving it a quick boost. This makes credit card companies feel comfortable giving you higher limits and lower rates.
You Can Improve Your Credit Score.
While your monthly payment isn't factored into your credit score directly, it does play a role in the health of your credit. There are three major agencies that track a person's credit, each of which uses a different scoring system (Equifax, Experian, and Transunion). When your credit score is checked, one of these agencies is used—generally, your score is reduced slightly per credit check.
Credit utilization—the ratio of your credit card balance to your credit limit—is generally 30% of your credit score. If your credit card balance is high relative to your credit limit, it will lower your credit score. A lower credit score can make it harder to qualify for credit cards and loans.
Minimum payments only lower your balance a small amount at a time because a large amount of your payment is applied to monthly interest instead of your credit card balance. What this means for your credit score is your balance to limit ratio remains high for the time it takes you to pay it down.
So if you have high card utilization (how much you use your card), and make minimum payments, it will take several months or years to reduce your utilization ratio. Experian uses a credit utilization ratio to rate credit utilization.
Total Debt ÷ Total Available Credit = Utilization Rate
This is your total debt divided by your total available credit, expressed in a percentage. The higher your utilization rate is, the lower your score will be.
If you have $5500 in total debt, and your total available credit is $11,000, you have a 50% utilization rate. You should try to keep your ratio lower than 30%, which demonstrates credit responsibility to lenders.
It Helps You Prepare for a Larger Loan.
If you plan to buy a home or make another large credit purchase in the near future, you might need to pay off existing debts to help you qualify for a loan or for a competitive interest rate.
Making minimum payments won't lower high credit card balances quickly enough to help you receive approval for a mortgage. Raise your payments to pay off credit card balances, and ensure your credit utilization ratio is lower before you make an application for a large loan.
You'll Increase Your Available Credit, and Have an Emergency Source.
Available credit is the amount of credit extended to you by a credit card company. If your balance is slowly decreasing because you're only making minimum payments, it will be several months (or years) before you can use your credit cards again.
Increasing your monthly payment amount allows you to pay your balance down quickly so you can free up available credit. If you have used all of your available credit, you no longer have credit to use in case of an emergency.
If your car breaks down, and you don't have the funds to pay for the repairs, you won't be able to finance them, either. This can be a dangerous situation to be in—you might not be able to get to work, which decreases your ability to pay your debts.
Managing your credit can be difficult. If you can resist the temptation to purchase items you may not need, keep your balance low, and make timely payments you will be able to live with a comfortable level of debt. Emergencies may not be as stressful, and you can begin to plan for larger purchases to make your life more pleasant.