Where a payment goes when card balance incurs multiple interest rates

This post originally appeared March 19, 2015 on CreditCards.com as “How payments are allocated on a card with different rates

By Barry Paperno

Dear Speaking of Credit,
Hello Barry, I found your column at CreditCards.com through a Google search and thought you might be able to help me with a credit card question I have. Something that’s generating a bit of confusion for me. Suppose I have a credit card that’s carrying a balance of, say, $800 (from a limit of about $2,000 if the limit is relevant). Suppose also that I want to make a purchase that totals about $300. If $300 plus the regular minimum payment is paid on time would the $300 I just spent be paid off? I ask because I can’t help but remember the time I paid $15 for a $1 bag of potato chips one month. If this isn’t a good idea, why not? Is there even any benefit at all to doing it this way? Thanks in advance for your time. — Harry

Dear Harry,
I sure hope that was a good bag of potato chips!

Your question of whether a $300 payment made on time this month would be paying off the $300 in new charges is a good one, as it raises the larger question of how credit card payments are applied to card balances, particularly when there are different interest rates for different portions of the balance.

The driving force behind how card payments are applied to card balances is the Credit CARD Act of 2009, a federal law that curbs credit card company abuses, such as unreasonable rate hikes and overlimit fees, and requires that consumers be provided with clear information about the rates and fees they’re paying.

Here’s how, according to CARD Act requirements, payments are applied to card balances:

Minimum payment
The minimum payment can be applied at the card company’s discretion, which typically translates into the minimum payment being applied to the lowest interest portion of the balance before any other higher interest portions.

Excess payment rule
Any payment amount left over after the minimum has been paid must to be applied to the portion of the balance with the highest interest rate. Once that higher interest portion has been fully paid, any remaining payment amount in excess of the minimum is to be applied to the next highest interest rate, and so on.

While we don’t know the makeup of your $800 balance, nor any interest rate(s) you’re paying, we do know that nowadays a typical credit card balance can consist of balance transfers, promotional low-interest rate purchases, and deferred or delayed interest plans — all at different interest rates. With this in mind, let’s look at how payments are allocated among different card balance examples using the dollar amounts you have provided:

Entire balance subject to one interest rate:
Here, with the entire $800 balance incurring a single interest rate, your entire payment — both the minimum and excess payment amount — will be applied to the $800 existing balance plus the new charges of $300. This example perhaps comes closest to answering “yes” to your question of whether your payment will be paying your new charges. Your $300 excess payment is, in effect, being applied to the $300 in new charges, since the net effect will see the excess payment amount covering the new balance and interest being assessed on the $800 balance less the minimum payment.

Balance subject to multiple interest rates:
In this example, the $800 card balance includes a $200 balance transfer amount at 18 percent and “introductory rate” charges amounting to $600 at 12 percent interest. Since multiple interest rates are being assessed, the CARD Act would allow the card company to apply the minimum payment to the portion of the balance earning the lowest interest — $600 at 12 percent. It would then require that $200 of the $300 excess payment be applied to the $200 balance transfer at 18 percent and the remaining $100 to your $600 balance at 12 percent.

Balance includes deferred and nondeferred interest portions:
Sales of big ticket items, such as appliances, commonly offer a deferred or delayed interest plan option in which there is “no interest if paid in full within X months.” The catch is that if the balance is not paid in full by the end of the promotion period, the interest jumps to a very high rate, such as 29.99 percent, and is calculated on the original balance as of the purchase date. Let’s say your card carries an $800 balance made up of $600 in deferred interest charges and $200 made up of other charges at 16 percent interest.

Consumers with deferred interest balances can take advantage of an exception to the CARD Act’s excess payment rule by choosing to have the excess payment applied to the deferred interest balance rather than the portion of the balance with the highest interest rate. For you, this would mean that, after your minimum payment is likely to be applied to the $200 at 16 percent, your excess payment of $300 would be applied to the $600 deferred interest balance, which would help ensure that this balance gets paid in full before the high interest kicks in.

Another CARD Act provision protecting consumers with deferred interest plans requires that the card company apply the last two payments made before the end of the deferred interest payment period to the deferred interest balance.

So, while it looks like your card balance would have to be subject to only a single rate of interest for you to be able to say your $300 payment is paying your $300 in new charges, should you have any other cards with portions of balances at multiple or deferred interest rates, you can thank the Credit CARD Act for your balances being paid down faster and less interest being charged to you than might have been prior to its passage.

Now, just avoid the potato chip aisle and you’ll have it made!

Have a question or comment?  Let’s hear it!

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