How Credit Cards Calculate Minimum Payment
Updated: Oct 22, 2019
Credit card minimum monthly payments are a black box, and only a small number of people
understand how financial institutions arrive at this amount. To make sense of personal finance, it is extremely important to understand how banks calculate the monthly payment and charge interest rates. In this article, we will reveal the minimum payment formula, shedding light on these mysterious digits.
Depending on the bank, the calculation of the minimum payment on a credit card may vary significantly. However, the law states that credit organizations should form it in such a way that the client can fully repay the debt.
Basics of Credit Card Interest
Interest rate, also called APR, is the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a loan, mortgage loan or a credit card. It can reach up to 29.99%, in some cases, it is variable, but more often it is fixed. This means that the interest rate may vary, decreasing or increasing. There is good news in all this, according to the law, the bank is obliged to warn the client about an increase in the amount of the interest.
At the same time, the variable interest rate is formed depending on the base rate, which is standard and is used to set interest rates for short-term loans issued to clients with high financial security.
The optimal solution is to give preference to the option where the redemption is carried out monthly. It greatly simplifies financial management.
Your Periodic Interest Rate
At the moment, banks are increasingly practicing the calculation of the average daily balance in the formation of interest payments. Based on the daily outstanding balance, the percentage is calculated on the card.
If you have a choice between two financial institutions, where the first offers a 15% APR with daily compounding and the other has their APR set as high as 15.5% but with yearly compounding, you should do some simple math before accepting the lower APR offer. The effective APR in the first bank would be
or 16.1798%, while the other is
or 15,5%. So as you can see the compounding period really makes a big difference.
Your Average Daily Balance
It assumes an increase in the amount of interest daily, if the balance is not repaid. Banks take into account the average daily balance, which we will explain later in this article, to generate average monthly payment.
How to count it? Let’s say your balance is $ 1,000 for interest for 10 days. You make a payment of $ 300 on the 11th day of the month. Then, at 21 days, you make a payment of $ 500. We get that the average daily balance on the card is $ 633. To calculate it we add all of the daily balances ($1000 first 10 days, then $ 700 for another 10 days and $ 200 last 10 days, given that the period is 30 days) and divide this amount by the number of days. ($ 1,000 * 10 + $ 700 * 10 + $ 200 * 10) / 30 = $ 633. It is the amount that the bank will take into account in the process of making interest payments.
To understand how a bank calculates interest, you need to know the average daily balance and the periodic interest rate. To find out these figures, you need to multiply the average daily balance, we got: $ 633 by a periodic interest rate – 0.041%, then you need to multiply the resulting number by the amount of days of the month. We define for 30 days in a month and get interest in the amount of $ 7.79. I.e. $633 * 0.041/100 * 30 = $7.79.
How to Calculate the Minimum Payment
In order to calculate the indicators correctly and use them for your own benefit, you need to clearly understand what the minimum monthly payment is. It represents the smallest amount that the cardholder pays for a specified period each month.
In this case, the amount can be constantly changing, because it is derived depending on the outstanding balance on the retirement payment.
In the vast majority of cases, the bank has its own minimum fixed amount in dollars. You can refer to your cardholder agreement to check the minimum rate or use this article to check the most common rates (which are at $ 25 in average) set by major card issuers.
There are two basic methods for calculating the minimum payment. They can vary depending on the company, but the essence is the same:
Flat Percentage. The outstanding credit balance must be multiplied by the percentage indicated by the bank. Usually, it is 1-3%, added fees. I.e. if your credit card balance is $5,600, you have an interest rate as high as 3%, your minimum payment will be $168.
Percentage + Interest + Fees. This includes late fees and other fees. For example, if your minimum payment is 1% and your outstanding balance is $7,000, your interest this month is $127, also, you owe $34 in late fees then your minimum payment would be ($7,000*0,01) + $127 + 34 = $241
Minimum Payment Calculations by Bank
Here's how some banks calculate minimum payments:
American Express: Payment options may vary by credit card. As a rule, most cards use 2% of the balance on the account
Bank of America: The percentage of this card issuer is 1% of the balance, together with late payments and financial expenses
Capital One: 1% of the amount charged, with various commissions charged. This includes late payments, financing costs, 1/12 of the membership fees.
Why Is It Important?
The ability to calculate the minimum monthly payment allows you to manage your personal finances in a better way. It gives you the opportunity in a short time to get rid of debts, save a decent amount, understand where you overpay, find out the optimal loan repayment time. Still, the best option would be the usage of personal management/debt repaying assistant software, such as Maiven, which will calculate everything for you and suggest the right amount to be paid.
Of course, banks consultants recommend to make payment when it is convenient. But why pay more, stretching payments for months / years, losing hundreds and thousands of dollars? This information helps you achieve proper distribution of funds, using the card for personal benefit, and not vice versa.