0% Balance Transfer Offers Can Be Beneficial, But Are Fraught With Pitfalls
One reader asked if a lower rate credit card if using a lower rate or 0% balance transfer offer was a good way to help manage and pay down credit card debt. The answer is a strong "maybe." (If you have a question you'd like answered, please click on ask a question button on this page)
Many people who use this strategy find themselves further behind than when they started. Here are some of the common pitfalls to avoid.
“QUESTION: How do you feel about moving credit card balances over to another credit card for a lower APR? For example, I receive an offer from xxxx to transfer balances at $5 – 3% with no annual fee for 15 months and after that the APR will be 15.74 APR which is still lower than some of my current APR rates.”
The Answer
Balance transfers to other credit cards with lower APRs can help you lower your overall interest costs, however there are significant potential risks associated with this strategy. To know whether it’s right for you, you want to evaluate a number of different factors and then run the math on if you will have a net benefit or a net loss.
Although you are not in this situation, if the 0% balance transfer card has a higher post-promotion interest rate than your current card, you may end up paying more total interest with the 0% offer. Make sure to also add in the up-front transfer fee to any calculation when comparing the cost of the two options.
Taking advantage of a strategy like this can be an effective way to help you manage your debt, but only if you combine it with a strategy of aggressively paying down the credit card balances during the promotional period.
You should also make sure to understand the potential pitfalls in this strategy and have a plan for avoiding them.
The Balance Transfer Fee
Most likely, you will be subject to the 3% fee on the balance transfer. The minimum amount of $5 in your example would only apply if you had around $175 in balances. If that is the case, don’t do the balance transfer and just focus on paying off the card balance directly. The balance transfer fee represents up front interest you pay the credit card company on day one. As a result, you should add the balance transfer fee to the interest calculation when comparing the two cards.
The 0% Offer
Realize a bank isn’t in the business of giving money away. Banks make their money off what’s called interest rate spread. When someone deposits $1,000 into a savings account, the bank loans that $1,000 out to someone who needs money. If the bank charges 5% on the loan, and pays 1% on the savings account, the banks profit is the 4% difference (5% income minus 1% costs). When a bank offers you a 0% loan, the bank actually loses money on the transaction. So banks have an incentive to make sure you don’t actually get the 0%
There are a large number of strategies and tactics a bank can put in the contract to eliminate your right to the 0%. One example is if you make a minimum payment late, even one day, they will take the 0% offer away.
Another tactic is the 0% offer may require you to pay the entire amount in full by a particular date, including any residual interest. Not calculating the correct amount could leave a residual balance which would trigger the nullification of the 0% rate.
If you break one of these esoteric rules, the bank doesn’t start charging you from that day forward. They go backward in time to when you first did the balance transfer and charge you all the back interest. As a result, the cost may be much higher to you than you might expect.
The Interest Rate & The Default Rate
Based on your question, you may not think losing the 0% offer is a problem. After all, the interest rate they are advertising is lower than your current interest rate. The trick, though, is the credit card may also have a default rate. A default rate is a higher interest rate you will be charged if you miss a payment or just make a payment a day late.
If you do make a mistake like this, not only will they charge you all the back interest, but your will be subject to the default rate rather than the normal interest rate. As a result, the interest you pay will likely be much higher than the main APR advertised. Default rates are often as much as 2 to 3 times the APR of the normal interest rate on the credit card.
Make sure to compare the default rates of your current credit cards and the new balance transfer card to determine which one is a better financial decision.
The Psychological Trap
The two biggest issues with balance transfer offers actually don't have to do with the credit card company. They stem from your subconscious. When you do a balance transfer to a 0% card, you will feel a sense of relief from your debt. As a result, you may not be as motivated to pay down the debt. This can result in you prolonging the debt and actually paying more interest over time.
Additionally, by having another credit card, you have increased the total amount of debt you could get into. Effectively, you just dug a deeper hole for you to potentially fall into.
Having significant credit card debt isn’t actually a problem. It is a symptom of weak financial management in other areas of your life. Simply lowering the interest rate doesn’t solve the fundamental habits that caused you to go into credit card debt in the first place. To solve the real problem, you need to change your habits.
The Solution
Without a change to the habits, the new lower interest credit card will just be one more way you can get deeper into debt. The first step must be to create a budget which allows you to live within your means, pay of your credit card debt, and save for your future. If you need help with this, you might want to first learn how to create a budget or hire a professional to help you.
Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at info@purposefulfinance.org