When to Do a Balance Transfer to Pay Off Credit Card Debt
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One of the pitfalls that many first-time (and even long-time) credit card users run into is racking up a balance that can't be paid off in one month. This might happen when you've had an unexpected financial emergency and things are tight one month, or because you ended up getting in over your head during the holiday season or while on vacation.
Having that debt hanging over your head can be difficult to deal with, especially when you consider the high interest rate you pay when you carry a balance. This is where a balance transfer can help your finances. Being able to move your money from a high-rate card to one that has a 0% APR can save you money and help you pay off your debt much faster. (See also: Best Balance Transfer Credit Cards)
How a 0% APR Balance Transfer Helps Your Finances
In order to make a balance transfer work, you need to open a new credit card account with a balance transfer special. Many credit cards will allow you to transfer a balance and then charge you no interest on the balance for set period of time, usually between six months and 18 months.
A balance transfer can save you money because you aren't paying regular interest charges. Let's assume you have a credit card with a balance of $2,500 with an APR of 19.99%. Your minimum payment is 4% of your balance each month. If you pay only the minimum payment, it will take you 9.42 years to pay off your debt, and you will pay $1,630.59 in interest.
Perhaps you decide that you want to pay off your loan faster than that. You decide to pay $250 a month. It will still take you 12 months to pay off your balance at that rate. You will pay $3,000 total, meaning that $500 of that will be interest. While it's an upgrade over paying $1,630.59 in interest, you could still do better with a balance transfer.
If you transfer your balance to a 0% APR card, you can avoid paying that $500 in interest. Not only that, but since your entire $250 payment will go toward paying off your principal each month, you could be done in 10 months instead of 12 months.
You can see how a balance transfer can improve your finances. However, you need to be careful. Not all balance transfers work smoothly, and you need to be aware of the pitfalls. (See also: The Hidden Dangers of Credit Card Balance Transfers)
Balance Transfer Fees and Introductory Periods
On the surface, a balance transfer looks straightforward. However, it's important to make sure the balance transfer is truly worth it.
First of all, you need to be aware that many credit cards charge balance transfer fees. Usually, the amount charged is usually 3%, 4%, or 5% of the amount you transfer. So, even though you aren't paying interest on the balance, you are still paying a cost.
In the example above, your balance transfer fee is likely to be either $75, $100, or $125, depending on the policy. It's still a good deal, though, since you are still saving in interest if you plan to pay $250 a month. You just might end up paying for an extra month, and your savings won't be quite as big.
Also, understand that balance transfers come with introductory periods. Once the introductory period ends, your balance is subject to the regular rate. If you want best results, you need to plan to have your balance paid off before the introductory period ends. In the example above, as long as your introductory period is at least 12 months, you can pay off your card without much trouble.
The story changes if you can't pay off your card within the introductory period. What if you have an introductory period of six months before your credit card APR jumps to 22%? Let's use the above example, but with a 4% balance transfer fee. In this case, you will repay a total of $2,600 (the $2,500 + $100 balance transfer fee). After six months of paying $250, your balance is down to $1,000. Now your interest rate rises, and it will take you another five months to pay off your credit card. You'll still have your card paid off in 11 months total, but now you will pay $250 in interest to finish it up.
In this example, it's still worth it, though, since you still wind up saving over paying 19.99% interest for 12 months, or over paying only the minimum for more than nine years. But, as you can see, your savings are diminished if you have large balance transfer fees and short introductory periods with higher rates after the intro period ends.
Before you make your balance transfer, figure out how much you can pay each month, and run the numbers to make sure that it is worth it for you to transfer the balance. In some cases, the costs of a balance transfer are large enough that it doesn't make sense to go through with it. (See also: What You Must Know Before Transferring Credit Card Balances)
Other Things to Know About Balance Transfers
There are some other things to understand as you look into 0% APR balance transfers. Take the following into account as you make your decision so that you don't wind up in worse shape than before.
1. You Might Not Be Able to Transfer Between Cards From the Same Issuer
Many issuers don't want you moving money between their own cards. So, even though you might like an offer from one of your present issuer's other cards, you probably can't move the balance. You need to make sure the new card is from a new issuer.
2. Debt Comes First
If you already have a good rewards credit card, looking for another rewards card that duplicates what you have isn't necessary. There are some cards that don't have a lot of benefits, but have the best 0% APR balance transfer offer. Take that offer to pay off your debt, and keep the good rewards card for use later, when things are under control.
3. Purchases and Your Balance Transfer Card
In some cases, purchases won't get the same 0% APR as your balance transfer. That means that you will have to pay interest on your purchases. The Credit CARD Act requires that issuers allocate a portion of your payment to the balance with the highest rate. On the surface, that seems to indicate that your payment will go toward your purchase balance, helping you pay off the higher APR balance.
This isn't the case, though. The CARD Act comes with a loophole that allows the issuer to allocate the minimum payment however it wishes. Let's say that, in addition to your balance transfer, you charge $1,000 in purchases at the 22.99% regular APR. Your balance is now $3,600 ($2,500 transfer + $100 fee + purchases). Your minimum payment might be $144. Now, in order to boost your debt pay down, you would want your entire $250 to go toward the purchase balance, with the higher APR.
However, the card issuer can allocate the $144 of the minimum payment to the 0% APR balance. So, only $106 reduces your high-interest debt. At that rate, it will take 6.75 years to pay off the $1,000 purchase balance, and you will pay $714.79 in interest. And that doesn't even include the fact that your balance transfer pay down is being hindered, and once the intro period is up you will owe a lot more in interest.
As you can see, making purchases when you are trying to pay down your balance is a bad idea. If you decide to make a balance transfer, you need to place a hold on additional purchases with that card.
Your balance transfer card can be a great financial tool. However, it's vital that you make a plan to pay off the balance before the intro period expires, and that you run the numbers to make sure it's a good move for you.