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Myth of minimum balance in credit cards


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Myth of minimum balance in credit cards

  1. 1. Myth of Minimum Balance in Credit cardsA lot of people have no idea on how their credit card works and what is the exact interest applications.Credit cards are in market mainly to make money from customers by charging them huge interestbecause they overuse their credit limit or just fall for the minimum balance option and get into debt trap.Let’s first understand few concepts like billing cycle and grace period to start withBilling CycleBilling cycle is duration for which you are liable to pay the due amount. e.g. from the period 6th Mar- 5thApr. It means that your bill gets generated on 5th of every month. This bill includes all the transactionsdone in the last 30 days. If you buy something on 7th Mar, that transaction will appear on the billgenerated on 5th Apr and if you buy something on 4th Apr, still it appears on the bill generated on 5thApr.Grace periodGrace period is number of days up to when you have the liberty to pay off your last bill. For example ifthe grace period is of 25 days, in that case you will enjoy no interest for next 25 days from the recentbilling date. In our example, as the billing happens on 5th of every month. You can pay off the bill till30th of that month, but after that you start paying the interest if you don’t pay the bill in full.Maximum number of days without interest?So now based on this info, what is the maximum number of days for which you can enjoy interest freecredit?? The answer is maximum 55 days! It’s because your billing cycle length is 30 days and graceperiod is 25 days, so if you purchase anything on the first day of your billing cycle, in this example say6th Mar, then it will actually appear on your bill of 5th Apr (30 days are gone) and you still get 25 days topay off this loan, so total 30+25 days = 55 days of interest free credit. However if you buy anything nearthe end of your billing cycle, like 4th Apr, then that will appear on the 5th Apr and you can pay off that innext 25 days, so in this case total 26 days of interest free credit.
  2. 2. Now this means that if you have any large purchase or any big ticket size purchase to be made, itsalways better to make sure you do it exactly in the start of the billing cycle to get maximum out of yourcredit card.Myth of Minimum BalanceDo you know that you start paying interest on your balance outstanding even if you have Rs 1 inoutstanding. Yes, if you don’t pay off your full balance by the end of the grace period, you will becharged with the interest from that point of time. Even if you pay off minimum balance, still you pay theinterest on the rest of the outstanding balance. A lot of people live in this myth that just because theyhave paid minimum balance, they will not pay the interest and can pay off the rest of the balance nexttime without any interest. This is totally wrong!Paying the minimum balance is just going to make sure that you are not charged any penalty for latefees. That’s the reason “minimum balance” is there. The worst part of this whole minimum balance thingis that once you have any outstanding balance in your credit card, the concept of grace period is lost.You keep on paying the interest on your outstanding balance at the end of your billing cycle. The graceperiod concept will only return once the 100% dues are cleared.This is one big reason why the credit card outstanding balance ballons to such a big amount once aperson starts paying only minimum balance. Lets understand this with a picture.Minimum balance are to make sure you don’t payfull?Minimum balance is a trick , pure trick to make sure you pay less and get into debt trap. Credit cardcompanies know very well, that if they do not give any option to pay minimum balance, people will haveno other option than to think “let’s pay off my bill in full”. But they know that if they put an option saying“minimum balance”, most of the people will then think – “Ok! this month let me pay this small amountand next month I will settle the full amount.” Sadly this is the first step for most of the people to get into
  3. 3. the debt trap, and this cycle never ends. As this strategy is a lifeline of credit card companies, theymake sure they take full advantage of this.How Psychology Affects Your Payment BehaviorA recent research study concluded that when a person looks at the amount of “minimum payment”, itcan influence how much of his balance he decides to pay off each month. The study looked at howpeople’s behavior changed when they saw a specific number as “minimum balance” and when they didnot see anything as “minimum balance”.A random sample of 481 Americans was taken and divided into 2 groups . One group saw a mockcredit-card statement showing a balance of $1,937, and an annual interest rate of 14%, but theydidn’t saw any “minimum payment” option. However one the other hand, the other group also sawthat the minimum payment of 2% of the balance was mandatory.What they found is that people who did not see any minimum payment number desired to pay ahigher amount of their balance — significantly more than 2% . Whereas people who were shown theminimum payment number were inclined to pay closer to 2% (meaning they’d be in debt longer)Example of Ajay paying Minimum BalanceLet us see an example to understand all the concepts and working of credit card. Lets take an exampleof Ajay Billing cycle 6th Mar – 5th Apr (30 days) Grace period 25 days Due date for payment 30th Apr Interest rate 3% per month (compounding) Purchases made during the billing cycle Rs 10,000Suppose Ajay pays minimum balance of Rs 300 and carries forward the outstanding balance for nextmonth and also spends Rs 5,000 more in next billing cycle.In this case as Ajay makes the minimum balance of Rs 300, then his outstanding balance would be Rs9,700 as on due date (30th Apr). Now his total interest will be charged on this Rs 9,700 and that wouldbe 3% of Rs 9,700 = Rs 291, which will be added to his outstanding amount and his final outstandingamount would be Rs 9,991 (just Rs 9 less than his original outstanding amount). Now as he carriedforward an outstanding amount on his credit card, there is no concept of grace period. Now in this billingcycle as he has spent another Rs 5,000. That will be added to his old outstanding and the total wouldnow be Rs 9,991 + 5,000 = Rs 14,991Now this time, suppose his minimum balance is Rs 400 (just for example) , and he pays it, then hisoutstanding balance will come down by Rs 400 and his final outstanding balance would be Rs 14,991 –400 = 14,591. Now as their will be no grace period , he will be charged the interest of 3% on hisoutstanding balance of Rs 14,591 , thats 3% of 14,591 = 437.73 and will be added back to hisoutstanding , 14571 + 437.73 = 15,008 (approx)
  4. 4. You can see that even after making the minimum balance he is actually having more than his previousoutstanding amount because of interest paid. Incase he does not pay the minimum balance also, in thatcase he will also be charged heavy penalty for late payment and that will be added back to his creditcard debt. You can see how the minimum balance gets one into debt trap.Making Minimum payment affects your Credit ScoreDo I need to give any other reason why one should stay away from minimum balance’s wheneverpossible. Making a minimum payment means not making full payment on time and the more number oftimes you do it, the worse your credit score gets each time. Read more on Improving your credit scorehereConclusionNow you know all the terminologies in credit cards and how it works exactly . You also came to knowabout how minimum payments work and how it gets you into debt trap. Try to make sure you becomemore responsible for your credit card payments.