It won’t be wrong to argue that the ‘buy now, pay later’ concept is perhaps what makes credit cards such a popular tool for payments for shopping. And to make it even more convenient, you don’t have to pay the whole due the very next month; you will get anywhere between 20 to 50 days to clear your dues without having to pay anything in interest charges.
You have three ways to clear your credit card dues – pay the minimum due, the total due, or any other amount in between. The minimum amount due is the least amount of the three, and therefore, an option that many choose. However, this is also the first step towards a potential financial disaster.
What You Need To Know About The Minimum Amount Due
There can be several consequences to paying just the minimum amount due on your credit card bill. Here are the critical factors:
How much is the minimum amount due?
It usually is 5% of the outstanding balance. For example, if you’ve spent Rs5,000 on your credit card the previous month, the minimum amount due will be Rs250 depending on your card issuer’s policy. There may be a cap on the minimum amount.
For example, one card has a minimum due of Rs 100. This means that, for example, on a total monthly spend of Rs 200, your minimum dues will not be Rs 10, but Rs 100. The minimum due amount is the least amount that you absolutely must pay by your payment due date. Otherwise, you will be charged a penalty known as a late payment fee.
How the late payment fee comes into play?
This is a flat fee that varies from issue to issuer but is in no way a small amount. It is usually upwards of Rs 500, at times around Rs1,000 if not more. This fee is a result of a directive issued by the Reserve Bank of India (RBI) that has mandated that banks can charge this fee if payment is later than three days after the payment due date. Banks can fix any amount as a late payment fee.
Paying only the minimum due results in a compounding of interest
This is the most important bit. Paying the minimum amount due might help you avoid the late payment fee, but you will have to pay the interest charges on the outstanding amount. Depending on the bank, the interest rates may vary. Usually, banks charge around 3-4% of the monthly credit card bill as interest. This may not sound like a lot, but when annualized, this becomes an interest rate upwards of 40 per cent per annum. Also, the longer you take to pay off your dues, the more interest accumulates on your outstanding balance. This is because the interest compounds every month the outstanding balance remains unpaid.
WHY PAYING THE MINIMUM AMOUNT DUE IS RISKY
When you pay only the minimum due, the bank will use that to offset the interest payment first, leaving most of the principal untouched. Essentially, you will enter into a debt cycle due to the compounding interest on your outstanding balance. As your interest amount keeps increasing, a larger portion of your payment will be used to clear only the interest and not the principal. So, your debt will decrease in no way. If this pattern is not corrected, you will find yourself in a debt trap. If you’re struggling to repay anything more than your minimum amount due currently, imagine how difficult it could get to clear your dues when they have snowballed enormously?
Impact on your credit score RBI has given banks the liberty to report late or missed payments to credit information companies. Once the bureaus receive such information, your credit score will take a hit. A score lower than 750 would make it difficult to avail any credit facility at favourable repayment terms (like at a lower interest rate) at best, and outright rejection of application at worst.
WHY YOU SHOULD PAY MORE THAN THE MINIMUM AMOUNT DUE
There are several advantages of paying more than the minimum due amount. You can save on interest: Almost all credit cards come with an interest-free period ranging between 20 and 50 days. Paying your bill within this period and in full means you will not pay anything extra for using your card. However, if you pay only the minimum due, you forfeit this benefit. Paying only the minimum due incurs interest on all your purchases. Also, you don’t get to enjoy any interest-free period until you’ve cleared all your dues.
You clear your debt faster: Credit card debt is a revolving debt, meaning, you never get rid of it completely until you’ve cleared it all. Each time you use your card, you’re in debt because you have to repay the used amount. But, if you keep using your card and pay only the minimum due every month, you’re snowballing your debt with added heavy interest charges. But paying more than the minimum due helps clear your debt faster because you’ll pay lesser interest.
You maintain a low credit utilisation ratio: Your credit utilisation ratio is how much credit you use against the total credit available to you. So, if you pay more, then the available limit increases, thereby lowering your overall utilisation. Ideally, you should not use more than 30 per cent of your available credit. But, paying only the minimum due shows a much higher use of credit.
This ratio is one of the determinants of your credit score where a higher ratio will lower your score. You improve your credit score: Along with the credit utilisation ratio, making payments on time and in full will be recorded in your credit report under ‘Payment History’. This is one of the biggest factors used to determine your credit score with at least 30 per cent or more weightage given to it. So, consistent payments will help pull up your score significantly.
Not planning your spending responsibly could lead to financial difficulties in the future and add stress in the present. Apart from paying interest, your credit score will be affected as well. As important as it is to pay more than the minimum amount due, it is just as important to use your credit card in a responsible manner. Even though you have a certain amount of time to clear your credit card bill, it is vital you must plan your spending in a way that you can afford to repay the dues in full on time.
The bottom line is pay the minimum amount due only when you don’t have any other option to clear your total dues on time. Making this a habit can have disastrous implications for your financial health.
The author is CEO, BankBazaar.com