How Do Credit Card Payments Work?
How many times after receiving a credit card statement in the mail have you actually stopped to look at it? To dig into the paperwork and find out more than just the amount of your minimum payment?
If you're like most people, you don't analyze your statement as often as you should.
We get it: life can be busy. Scrutinizing your credit card statement isn’t the way most of us choose to unwind and relax.
But do you know what part of your payment goes toward the principal on your balance? Or how the rest of your payment affects the interest that you’re charged?
What about how credit card companies apply your payment to different APRs? Did you know the APR on regular purchases, cash advances, and balance transfers can all vary?
It’s important to understand how credit card payments work. Once you know, you can better use your credit as a tool to improve your finances and reach your goals.
A well-executed payment strategy can help you shorten the amount of time you spend paying down balances. It can also cut the total amount of interest you have to pay, too.
Review Your Credit Card Statements and Balances
Know where to find information on your statement. Locating the information is the first step to understanding your credit card payments.
Every statement should include your balance, interest rate, and a list of recent transactions. The statement should also list the due date and the minimum payment that you need to make on what you owe.
Credit card companies calculate minimum payment amounts as percentages of your outstanding balance. And your balance might consist of more than just one type of transaction. There are normal charges for purchases you made with your card. But your statement will also list any balance transfers or cash advances that you made.
The interest and any applicable fees add on to your outstanding balance. That's where things become a little complicated.
What Happens When Difference Balances Have Different APRs
Each type of transaction can carry a different interest rate. You could have one credit card statement with several different interest rates charged.
This detail of how credit card payments work is often overlooked. Different types of balances come with different APRs. That could have a significant impact on how your payments apply to your balance.
Let’s look at an example to better understand how this part of your credit card payment works. When you make a minimum payment, that goes toward the balance with the lowest interest rate first.
Say your credit card has a balance of $2,500 with the following breakdown:
- Purchase balance: $700 at a 24% rate
- Cash advance balance: $850 at a 19% rate
- Balance transfer balance: $950 at a 13% rate
If you only make the minimum payment, the credit card company will apply that payment to the lowest interest rate balance.
But it's different if you pay more than the minimum amount due. The way credit card companies must apply payments is federally regulated. These regulations now require the portion of a payment that exceeds the minimum to go to the highest interest rate balance first.
This wasn’t always the case. President Obama signed the Credit CARD Act into law in 2009. Before that, credit card companies applied your payment to the lowest interest rate balances. Even payments over the minimum worked this way.
Now, when you make more than the minimum payment, only the portion that covers the minimum payment will reduce the balance with the lowest APR. The rest goes toward the balance with the highest APR. This helps you pay off your balances faster and cheaper than you could if you only paid down the lowest rate balance.
Here's an even more in-depth example to highlight the way your payment will be applied when you have two different interest rates on one card:
Credit Cards: Different APRs on Different Balances
|Credit Card Interest Rates||15.99% APR on Purchases, 0% APR on Balance Transfers||0% APR on Purchases, 15.99% APR on Balance Transfers||15.99% APR on Purchases, 4.99% APR on Balance Transfers||15.99% APR on Purchases, 15.99% APR on Balance Transfers|
|Interest Charged on Purchase Principal||$65.71||$0||$65.71||$65.71|
|Balance Transfer APR||0%||15.99%||4.99%||15.99%|
|Balance Transfer Principal||$5000||$5000||$5000||$5000|
|Interest Charged on Balance Transfer Principal||$0||$65.71||$20.51||$65.71|
|End of Month Principal Owed||$10,000.00||$10,000.00||$10,000.00||$10,000.00|
|Total Interest Charged on End of Month Principal||$65.71||$65.71||$86.22||$131.42|
|End of Month Balance Owed||$10,065.71||$10,065.71||$10,086.22||$10,131.42|
|Total Monthly Payment||$500||$500||$500||$500|
|- Portion of Monthly Payment Toward Lowest-APR Balance||$165.71||$165.71||$186.22||$231.42|
|- Portion of Monthly Payment Toward Highest-APR Balance||$334.29||$334.29||$313.78||$268.58|
|New Purchase Principal||$4,731.42||$4,834.29||$4,751.93||$4,815.71|
|New Balance Transfer Principal||$4,834.29||$4,731.42||$4,834.29||$4,815.71|
|New Total Balance||$9,565.71||$9,565.71||$9,586.22||$9,631.42|
What to Know About Credit Card Payments on Deferred Interest
There is one exception to this. Deferred interest doesn’t follow the highest interest rate first rule.
This is the “pay no interest for X months” plan that you often see with store-branded credit cards. This can be a great deal if you can manage your credit card payments. Make the payments, pay off the balance, and pay no interest. Sounds good, right?
But there is a catch. If the balance is not paid off in full by the end of the promotional period, you pay the interest on the entire balance. The same is true if you miss just one payment during the promotional period.
In other words, interest is retroactively charged. And sometimes that interest rate is much higher than it would have been. And that's not just for deferred interest on purchases. It could also apply to balance transfers as well.
However, you can apply credit card payments above the minimum to deferred balances first. You’re not required to apply it to the balance with the highest interest rate.
Let's say your credit card carries a $1,000 balance. That includes $500 in deferred interest charges, $300 in purchases charged at 13% interest, and $200 in balance transfers charged at 20%.
Once the minimum payment applies to the $300 at 13%, you can put any additional amount to the $200 balance.
This balance comes with the highest interest, making it the default option. But it’s your choice. You can apply the payment toward your deferred balance of $500 instead.
Since the deferred balance stands to increase the highest of the three, it makes financial sense to pay down the deferred interest first. You want to pay that off before the promotional period ends. Don't allow excess payments to be automatically applied toward balances with the highest interest.
Larger Payments Mean Less Interest Paid
Credit card balances should be paid in full every month to avoid interest charges. While this makes complete sense in theory, only about 45% of American credit card users pay their balances in full every month.
The other 55% carry balances forward from month-to-month.
Do you make minimum payments on your credit card and carry a balance? You can make a huge difference by making a bigger credit card payment. You’ll save money on interest charges and pay off your balance faster.
The minimum payment for most credit cards is a percentage of the current balance. It’s usually around 1% to 2%. This includes any interest and late fees for the month.
Let’s assume your credit card has a $2,000 balance with a 20% interest rate. Now, let’s take a look at two different scenarios. In one, you only make the minimum payment. In the other, your payment is the minimum plus $10 more.
Making the minimum payment:
You make the minimum payment of $40 per month on your $2,000 balance. It will take 108 months to pay off your debt. Remember, your balance is $2,000. But by making the minimum payment, you pay $2,335 in interest. That’s more than the amount of your balance!
Making $10 more than the minimum payment:
Now let’s say you make a monthly payment of $50. That’s $10 more than the minimum you need to make. Instead of taking 108 months to repay your debt, it will only take you 66 months. You’ll still pay interest. But your interest charges will be $1,323. That’s about a thousand dollars less than if you made the minimum payment.
The verdict here? By paying just $10 more than the minimum amount due on your credit card, you can save $1,000 in interest payments. You’ll also pay the debt off four years sooner than you would if you only paid the minimum.
Tips to Cut Down on Interest Charges on Credit Card Payments
The easiest way to avoid interest charges? It’s simple. Pay off balances in full every month.
This means only charging what you can afford to repay to your credit card. Treat it like cash or a debit card. If you don’t have the money in your account to pay off the balance, don’t charge it!
What if you already have a balance on your credit card? It’s time to create a plan to pay it off as soon as you can. The sooner you pay off debt, the less you pay in interest charges.
Start by setting up automatic drafts from your bank account. Pay more than the minimum payment, too. Remember, just $10 more than the minimum goes a long way! Automatic drafts from your bank account ensure that you never forget to make a payment. This helps you avoid missed or late payments - and additional fees.
You can also avoid interest by using a 0% APR credit card. This puts you on a deferred interest plan we talked about earlier. If you decide on this option, you need to use your credit card responsibly.
If you obtain a balance transfer credit card like this, you need to make every single payment on time and in full. You also need to pay off the balance before the end of the promotional, 0% interest period. If you miss a payment or don’t pay off the balance, interest applies to your balance retroactively.
That’s helpful because your entire payment goes directly to your balance. Again, make sure you can make payments on time and in full. Otherwise, the promotional, lower-interest period may end while you still have a balance. You’ll miss out on the advantages of a balance transfer.
Make the Most of Your Credit Card Payment
Now you know how credit card payments work. You also understand how interest can impact your financial situation, and have tips on avoiding those charges.
This is the knowledge you need to better manage your credit and build a strong credit history and score.
If you feel your credit card company doesn’t apply your payments correctly, you have a right to call them and discuss the issue. You also have a right to file a formal complaint with the Consumer Financial Protection Bureau.
The CFPB, charged with working on behalf of consumers regarding financial products will act as a mediator between you and the card-issuing bank until the issue is resolved.