Why Paying the Minimum Monthly Payment on a Personal Loan is a Bad Idea
At first glance, paying your regularly scheduled monthly bills is a necessary component in keeping debt down – and keeping your credit score up.
After all, staying current on your personal loan debt – or any personal debt for that matter – is given a high priority by the credit scoring agencies that produce your personal credit score. The primary credit scoring formula, created by Fair Isaacs (FICO), assesses 35% of a total credit score based on staying current on personal debt.
Even so, staying current on personal loan or credit card debt doesn’t mean much if you’re only paying the minimum amount due on your monthly debt load. That just means you’re only treading water on debt and won’t erase that debt for years, maybe even decades, if you keep paying the minimum balance due every 30 days.
“It’s a bad idea,” says John Davis, founder of ScoreSense, a Dallas, Tx.-based credit score services company. “By making the minimum monthly payments only, you’ll end up paying a lot more in the long run. Consequently, It’s always advisable to pay above the minimum payments.”
According to Davis, any amount paid above the minimum is used to deduct from the balance of the loan.
“For example, let’s say you have $5,000 in debt on a credit card with a 19% interest rate, and you pay $200 per month,” he says. “At this cadence, it’ll take you 33 months to pay off the balance. However, if you double your payments to $400 each month, your $5,000 will be paid off in 15 months.”
Why do personal loan and other lenders offer low-end minimum payments to borrowers? It’s by design, as lenders and creditors clean up when borrowers take longer to pay down their debt.
“Paying the minimum monthly payment is encouraged by your lender because the longer it takes you to pay the full balance the more you pay in interest to your lender,” says Paul A. Etienne, a finance and investment consultant based in Naples, Fl.
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Getting Ahead of the Bare Minimum
There is a better way to pay off your debts – just make sure to keep paying those monthly debt payments, no matter what.
“If you don’t have more than the minimum payment, then don’t miss your payment by paying at least the minimum each month,” Etienne says. “if you can afford to pay more you should always pay more than the minimum payment by contributing more money towards the debt or loan principal.”
Paying off more than the minimum debt has its variables that are largely dependent on the form of personal debt.
“Whether to pay just the minimum or more depends on your financial goals and the type of debt you have,” says Lauren Bringle, an accredited financial counselor and content marketing manager with Self Financial, in Austin, Tx.
Credit card debt. If your goal is to pay off your debt, pay more than the minimum whenever possible, especially on higher-interest credit card debt. “With credit card debt, if you only pay the minimum each month, interest continues to accrue on the rest of your balance. Over time, this interest could add thousands to your original total.”
Installment loans (like personal loans.) While prepaying on installment loans, such as personal loans, could save interest payments over time by paying the principal off early, this may not be a big priority compared to credit card debt. “If you have a fixed monthly payment on something like a personal loan for a fixed length of time, interest doesn’t often accrue on personal loans like it does on credit card debt,” Bringle adds.
Pay High Interest Rate Debt First
How you prioritize your personal debt also factors into any minimum payment scenarios.
“I prioritize most of my debts in order of which one has the highest interest rate and the lowest balance, to pay those debts off first,” Bringle says. “Essentially, I balance between the debt avalanche method (where you pay the highest interest debt first) and the debt snowball method (where you pay the lowest balance off first). I do this because I can benefit from saving the most on interest while also staying motivated by paying a lower balance off first, then snowballing my payments towards other debts.”
As for the order of personal debt paydowns, Bringle ranks them in terms of priority (meaning you should pay these debts off first, ideally with paying more than the minimum monthly payment.)
1) High-interest, consumer debt (like credit cards) or higher-interest personal loans or car loans
2) Private student loans, which often come with higher interest rates or variable interest rates, followed by
3) Federal student loans, which typically have more protections and lower interest rates. Right now, federal student loans have 0% interest through December 31, 2020.
Medical debt is a different breed than a personal loan or credit cards, and should be treated differently when it comes to debt elimination.
“Most medical debt does not accrue interest, and many medical providers offer their own payment plans,” Bringle adds. “If you work directly with your provider and can make at least the minimum monthly payments towards medical debt,
focus on paying off other, higher-cost debts first.”
The Takeaway on Paying the Minimum on Personal Debt
The expert consensus is clear on the matter of minimum debt payments.
“When making monthly debt payments you should not only pay the minimum balance the issuer suggests,” says Michael Broughton, co-founder and CEO of Perch, a fintech-based mobile app firm that helps consumers address debt and credit issues. “In doing so, you’ll incur a great deal of interest to your total balance due.”
Broughton advises combining all your debts into one lump sum (a personal loan here is a good idea) so you only have to worry about making one monthly payment rather than multiple payments. “By doing this, you avoid possibly missing payments and hurting your credit,” Broughton says.
Lastly, make sure you have an accurate household budget to act as a foundation for paying off debt more quickly. “Make sure you know that your expenses are balanced with your income including the repayment of all your debts,” Broughton adds. “Using a budget will ensure that you can consistently pay back your debts month to month.”
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Brian O'Connell has been a finance writer at TheStreet, TheBalance, LendingTree, CBS, CNBC, WSJ, US News and others, where he shares his expertise in personal finance, credit and debt. A published author and former trader, his byline has appeared in dozens of top-tier national publications.