Credit card Q&A: “How are credit card payments applied to balances?”
Back in the good old days (as far as credit card issuers were concerned), credit card payments applied to balances with the lowest APR first, followed by higher APR balances.
This practice was known as negative payment hierarchy, and essentially allowed credit card issuers to charge finance charges hand over fist and trap consumers in a never-ending debt spiral.
It took some time, but policymakers finally got wind of the shady practice and eventually outlawed it as part of the Credit Card Accountability Responsibility and Disclosure Act (CARD Act), which was enacted in early 2010.
Low-Rate Balances Paid First*
Thanks to the passage of the CARD Act, credit card issuers must apply consumer credit card payments a little bit differently.
What hasn’t changed is that the minimum credit card payment is applied to the balance with the lowest APR.
So if your minimum payment due is $20, and you’ve got multiple APRs, such as purchase APR and balance transfer APR on the same card, the lowest one will be paid down first with your minimum payment.
This is essentially the same as the old practice, which clearly wasn’t kosher.
However, it’s not that simple – nothing ever is…any amount beyond the minimum payment will generally be applied to the highest APR balances first.
In other words, if you only make the minimum payment due on your credit card each month, negative payment hierarchy is still in effect. And you’re pretty much getting a raw deal.
For example, if you’ve got purchase APR of 0% APR, and took out a cash advance at 29.99% APR, minimum payments would go toward the 0% APR balance.
All the while, the cash advance balance would remain untouched and grow larger and larger before your very eyes.
Assuming you make credit card payments above the minimum amount due, the excess will go toward the highest-APR balances first.
So if you’re in a situation where you have multiple balances on one card, all with different APRs, you’ll want to ensure that you make more than the minimum payment, if at all possible.
Otherwise you’ll be hit with hefty finance charges, especially if the highest APR is sky-high, which it often is with a credit card.
Minimum payment = applied to lowest APR (bad)
Amount beyond minimum payment = applied to highest APR (good)
If you aren’t able to make more than the minimum, and see your high-APR balances growing as a result, consider executing a credit card balance transfer.
Moving the high-APR balances to a 0% APR credit card could save you a ton of money, and make it easier to wrap your head around how the credit card issuers are charging interest.
[How much does a missed credit card payment lower your score?]
Does the New Rule Really Help?
At first glance, the rule sounds like a godsend to consumers, but in reality it seems to be more a concession to the credit card issuers than anything else.
If you think about, many consumers who get into credit card debt probably only make the minimum payment each month.
So for these consumers, the new rule accomplishes absolutely nothing. They continue to see their low-APR balances paid off first, while their high-rate balances fester and grow.
And for those who make more than the minimum payment, only the amount that exceeds the minimum actually goes toward the high-APR balances.
That means a small portion of the high-APR debt is targeted in many cases, which is a win for the credit card companies.
But policymakers had to strike some sort of agreement. And if the entire payment were applied to the highest APR balances first, credit card issuers would likely need to make up for the reduction in income elsewhere.