What is a Minimum Monthly Payment?
A minimum monthly payment is the lowest amount that must be paid in a month regarding a revolving credit facility, such as a credit card. If the user of the revolving credit does not make the minimum monthly payment, they may be charged late fees and risk damaging their credit score. Usually, the minimum monthly payment is calculated as a small portion of the total credit balance owed.
Minimum Monthly Payment Explained
A minimum monthly payment applies to users of revolving credit accounts. The borrowers must make at least a minimum monthly payment without incurring any penalties. It differs from a standardized traditional loan, which pre-determines the amount that needs to be paid back, and the exact date it needs to be paid back.
Small, unpaid balances are usually charged a fixed rate of interest that accrues daily. The importance of making the minimum monthly payment is to preserve an individual’s credit score.
A credit score is a number that is between 300-850 that represents an individual’s credit quality. A higher score means that a borrower is more attractive and less risky, whereas a lower score indicates that a borrower is riskier. As a result, individuals with high credit scores may receive more favorable interest rates, and those with low credit scores will be charged higher interest rates.
Revolving credit refers to a line of credit, which is a pre-determined borrowing limit that can be drawn upon at any time. For consumers, this comes in the form of a credit card. Credit cards are cards made of plastic or metal issued by a financial services company that allows the cardholders to borrow funds to pay for goods and services.
In return, they are charged fees and interest. Lines of credit can be drawn down as far as a certain limit allows and can be reused as long as they are repaid.
Credit cards usually charge higher interest rates than other consumer loans, and the reason for the move is to compensate for the higher risk that they pose to the issuer.
Many credit cards are issued to people with little to no credit history or even poor credit history. Furthermore, there are usually no assets to back the borrowings, which makes it an unsecured form of debt. Additionally, there is very little protection for issuers to stop consumers from simply walking away from the debt. It is a large risk to the issuer and is compensated by a higher annual percentage rate (APR).
Credit card issuers must give a grace period of 21 days before interest on purchases begins to accrue. However, the interest rates are much higher than other forms of loans. Therefore, users of credit cards are advised not to let their credit card balance accumulate and become too large. Generally, users should settle their credit card balances as soon as possible, and only make the minimum monthly payment if they are extremely tight on liquidity.
Lines of Credit
Lines of credit provide access to money “on-demand” like credit cards. Lenders offer such lines of credit to fund the liquidity needs of both consumers and businesses. Interest is only charged when funds are borrowed. They come in two forms:
1. Secured lines of credit
One of the most common forms of secured lines of credit is the home equity line of credit (HELOC), which allows homeowners to borrow money against the equity portion of their home and use the home as collateral for the line of credit. It reduces the risk from the lender’s perspective since if you default on the loan, they can seize the home and re-sell it to cover the losses.
A key thing to note is that a borrower can only borrow against the equity, or the amount that they’ve paid themselves. So, borrowers cannot extend a HELOC on the entire value of their home.
2. Unsecured lines of credit
Unsecured lines of credit are not backed by an asset. Because of the increased risk, they generally charge a higher interest rate to compensate. Credit cards are generally considered a form of unsecured lines of credit.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: