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Minimum payment formulas make a big difference in costs

Summary

On a statement, the interest-plus-1-percent formula might look like interest is counted twice — but it actually speeds up repayment

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Are credit cards charging interest twice when they include interest in the minimum payment as well as the calculation of new balance?

In a word, no. But it can sure look that way on your statement.

The card statement shown below replicates part of a real monthly statement for a Chase card. The left hand column under “Account Summary” totals up the new balance. The new balance includes monthly interest of $43.62.

The right hand column under “Payment Information” shows the new balance and the minimum payment. The formula for minimum payment – as with most cards – is 1 percent of the balance plus interest. (If that results in an amount less than $25, the minimum payment is $25.)

statement shows interest and minimum payment

Accordingly, on the right, where the minimum payment is calculated, the $43.62 in interest is included in the minimum payment of $67.

“This is adding the interest twice!” a cardholder said in an email.

The reader noticed that his other card, from Pentagon Federal Credit Union, used a different formula to calculate the minimum payment. Pen Fed charged 2 percent of the new balance. It didn’t mention anything about interest in its minimum payment – and the minimum payment was lower.

“If this [interest plus 1 percent] is legal, why doesn’t Pen Fed apply the same formula?” he said.

But the fact that interest appears twice on the Chase statement doesn’t mean that it is being double-counted. And under regulatory guidelines, card companies can calculate the minimum however they want – provided it results in paying off the balance in a “reasonable period of time.”

The math of minimum payments

The interest-plus-1-percent formula only sets the amount of the minimum payment. It doesn’t affect the new balance, which is the calculation of what you owe. The interest is added once into the new balance. Then it is used to calculate the minimum payment.

So why is the interest-plus-1-percent payment larger than a 2 percent of new balance payment? (Other things being equal – the interest rate and existing balance.)

The average APR for cards that carry a balance is 15.5 percent, according to the Federal Reserve. For cards with this rate or higher, the fact you’re paying a minimum based on all the month’s interest plus a small chunk of the outstanding balance ensures that you are paying down the debt.

Payments calculated this way will pay off the debt quicker than payments set at 2 percent of the new balance. (The exception is for smaller balances where the dollar minimum payment of $25 kicks in.)

  • For example, the average consumer’s credit card debt of about $5,500 would take 226 months – almost 19 years – to pay off at the interest-plus-1-percent level, assuming the average interest rate of 15.5 percent.
  • If minimum payments are 2 percent of the balance, the time to erase the debt extends even further to 290 months, or 24 years.
  • The interest savings on the faster payoff formula is $2,303. So rather than paying interest twice, you’re saving on interest by paying down the balance faster with the interest-plus-1-percent formula.

Both examples assume a monthly dollar minimum payment of $25. That’s the dollar minimum on the Chase card, and it’s a typical floor that card issuers set.

For smaller balances, more of the payments are at the dollar minimum, narrowing the payoff time between the two formulas. For example, a balance of $1,000 will take 57 months to pay off with either formula.

See related: Minimum payment survey: How much your issuer charges

How minimum payment formulas differ

While most of the largest card issuers use the interest-plus-1-percent formula, the 2 percent minimum payment formula is still hanging on in the credit card world.

A review of more than 2,000 card agreements on file with the U.S. Consumer Financial Protection Bureau found 87 that use the 2 percent method. Discover is the largest – and the list includes some big credit unions like Pen Fed and Navy Federal Credit Union.

To be fair, credit unions have among the lower posted interest rates for credit cards. A lower APR and a minimum payment of 2 percent of the balance will mean a faster payoff and lower total interest costs.

  • For example, Navy Federal’s posted interest rates for a Platinum Visa/MasterCard start as low as 7.49 percent APR.
  • At that rate, using the 2 percent of balance minimum payments, the average balance of $5,500 will take 14 years to pay off.

That’s still a long time, but a lot shorter than the 19 to 24 years it takes to pay off the same balance at 15.5 percent APR. At lower interest rates, the 2 percent of balance minimum payment produces a faster payoff than interest plus 1 percent.

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Published: July 17, 2018

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