For many people, the amount of money their creditor asks for as a monthly minimum payment is a mystery, changing occasionally but for an unforeseen reason. Understanding how your credit card interest and monthly payment is calculated is important. Not only does it help you become more informed, it also helps you use your credit card more effectively and save money.
Each credit card company actually has its own way to calculate a minimum payment on your account, although they are all required by law to set a minimum payment that will allow the customer to pay at least some principle, eventually paying off their debt completely.
If you have ever wondered how your minimum monthly payments are calculated or the puzzling formula behind monthly interest charges, the truth is it isn’t that complicated once you understand how the system works.
Minimum Payment Regulations
While many individuals feel sometimes that a lower minimum due would be a good thing, this is far from the truth. In 2003, federal regulators stepped in because minimum monthly payments had gone so low that cardholders found themselves with debt that just kept growing, despite making no charges. This is called negative amortization.
Negative amortization is when your minimum monthly payment is actually less than the interest charged to you monthly and it basically ends up adding to your debt, not decreasing it.
Here’s an example of just how harmful negative amortization can be. Assume you have a credit card with a $4,000 balance. Your minimum due is $20 so you send in your payment. Next month you receive your statement and see that the amount of interest charged to the account for the month is $75. Your balance is now $4,055. You pay your minimum $20 again and next month your balance has climbed to $4,110.
Federal regulators changed the rules and set a new standard, forcing minimum payments to “amortize the current balance over a reasonable period of time.” No specific formula was set, although this is what forced credit card companies to make sure your minimum payment is at least somewhat higher than the month’s accrued interest.
The Basics of Credit Card Interest
Your credit card interest rate is also called an annual percentage rate, or APR, which can be as high as 29.99%. This rate, called the nominal rate, usually ends up being an “effective interest rate” that’s a little higher because interest gets factored in.
The APR associated with your card can be fixed or variable. Fixed means it always remains the same. Variable rate interest, which is by far the more common of the two, means that the interest rate you are charged can rise or fall. Luckily, your bank is required by law to notify you before raising your rate.
Your variable interest rate is based on the “prime rate”. The Prime Rate is a standard interest rate that banks use to set their interest rates on short term loans to their most creditworthy customers. If you want to learn more about the Prime Rate, you can read this article.
The best plan is to pay off your balance in full each month. Then you will not need to worry about finance charges.
Your Periodic Interest Rate
Most credit card companies today used something known as the average daily balance method to calculate your interest charges. This means that interest is compounded based on the daily balance on your account.
You aren’t charged interest on a yearly basis. As the interest compounds daily (a little interest is added to your unpaid balance every day), you can figure your daily rate by dividing your APR by 365 or 360, depending on the bank. As an example, say you have an APR of 15%. That works out to a periodic interest rate (or daily periodic rate) of 0.041% a day.
Your Average Daily Balance
This is another area that can be confusing, as the amount of interest you owe increases every day you do not pay the balance. Because you do get credit for paying off some of the balance early, your bank looks at your average daily balance, which is the average amount of your unpaid balance over the course of the month.
As an example, assume you have a $1,000 balance for 10 days accruing interest. On the 11th day of the month, you make a $300 payment. On the 21st day, you pay another $500. This means your average daily balance is $633, which is what the bank uses to calculate your interest charges.
Calculating Interest Charges
Once you know your periodic interest rate and your average daily balance, you can see how the bank charges you interest.
Just multiply your average daily balance ($633 in the above example) by the periodic interest rate (0.041%), then multiply it by the number of days in the month. If the month has 30 days, this example would mean interest charges of $7.79.
How to Calculate Your Minimum Payment
The minimum monthly payment on a credit card is the smallest amount you need to pay by the due date each month. Your minimum payment will likely change month to month, as your bank bases it on your unpaid balance at the end of the billing cycle.
Most credit card issuers have a minimum fixed dollar amount that the minimum payment cannot fall below, such as $20 or $25, except when your outstanding balance is less, in which case the total card balance is due.
The formula for calculating the minimum due can vary a bit by card issuer. There are two basic ways to set a monthly minimum payment:
- Percentage + Fee. This means your balance is multiplied by a percentage (usually 1% to 3%), then any fees are added (including late fees).
- Percentage + Finance Charge. Your balance is multiplied by a percentage and a finance charge is added. On top of that, other fees, including late fees, are then added.
Want a Faster Way?
If you just want to quickly figure out your expected minimum monthly payment, check out our Minimum Payment Calculator
Minimum Payment Requirements by Card Issuer
Here’s a helpful guide to today’s top credit card issuers and their minimum payment calculation policies.
- American Express: American Express has a number of calcuations they use depending on the credit card, although it’s usually 2% of the balance.
- Bank of America: 1% of the balance, along with finance charges and late fees.
- Capital One: The full balance is due if under $15, otherwise 1% of the balance plus finance charges, past due ffees and 1/12 of the membership fee.
- Chase: The greater of the following is due each month: 2% of the balance or 1% plus any interest and fees.
- Citi: All past fees and finance charges are due, plus anything over the credit limit, along with the greater of the following: the new balance is under $20; $20 if the balance is at least $20; 1% of the new balance plus fees and finance charges; or 1.5% of the new balance
- Discover: 2% of your balance is your minimum due, or a minimum of $15 plus finance charges and fees.
- USAA: The full balance is due if under $15; 1% of the balance, plus finance charges and fees, not to be under $15.
- US Bank: According to US Bank, the minimum payment is calculated using the greater of the following: 1% of the balance, plus finance charges and fees; or a minimum of $10.
- Wells Fargo: If your balance is under $15, the entire balance is due. Otherwise, 1% of the new balance plus finance charges and fees.
As you can see, minimum payment calculations vary amongst all credit card issuers, although all are similar and stick to around 1% of the balance, plus fees and finance charges.
Why It’s Important
Understanding how your minimum due is calculated is a great way to see how to get yourself out of debt because you’ll understand how much of your payment is going to the principle and how long it will really take to pay off your balance using only minimum payments.
Most financial advisers will tell you to pay extra when you can. By just paying the minimum, you may add years to the loan, and hundreds, if not thousands, of dollars in finance charges.
Ultimately, your goal is to achieve credit card balances that you can pay in full each month.