What is a balance transfer?
Credit cards come with a limit often referred to as a revolving limit. You go to the store and swipe your card and as long as your outstanding balance is lower than the limit + new charge it goes through.
Some credit cards also have a feature called a balance transfer. The is derived from transferring the balance from one card to another card. Say you have high-interest credit card debt on Card A, and Card B wants your business. Card B would happily pay off your debt on Card A to make you a customer. So they take your $10,000 you owe on Card A, pay it off, and now you owe $10,000 on Card B, hopefully at a lower interest rate, probably 0% (why else would you do this?).
Some cards will also just deposit the cash straight into whatever account you name, such as your savings account, if you provide them the routing number and account number.
This can be an excellent way to take control of your debt and reduce the interest you may be paying on other cards or loans of any kind.
What’s the catch?
Done correctly, this is a powerful tool. But banks aren’t charities. There is often blood in the water. They see someone with a debt problem and that smells like opportunity to them. They may be hoping that after the low promo APR period is up, you will still owe them and you will start accruing or have already accrued a lot of interest.
Balance Transfer Fees – there are many balance transfer offers that claim “0% APR for 12+ months!!!” Oh sweet, let’s sign up! Not so fast. Many cards have a 3-5% balance transfer fee. In the case of our $10,000 example above, this means it will cost you $300-500 to do a balance transfer (10,000 x .03 or .05). They will pay off your $10,000 debt, and you will owe them $10,300-10,500. If the 0% APR promotion is only good for 6 months, that would mean you need to pay $10,300-10,500 off in 6 months to avoid additional interest. That really comes out to about 6-10% annualized interest (3% or 6% x (12 months/6 months)). Now, if you are paying annualized interest higher than that amount, it could still make sense to do such a transfer if you are confident you can have the debt paid off by the end of the promotion period. But, there are actually balance transfer offers that don’t have fees. Those are the best – if you qualify for them.
3-5% balance transfer fees for 0% APR feels like bait and switch. Technically, it isn’t. But effectively, if you pay the “loan” off in time, you will have paid back a certain % more than the amount you borrowed, and that feels like interest to me. If I am a banker reading this, I am wondering if there might eventually be a lawsuit on this topic and all these fees eventually refunded to people who didn’t read this blog. Work in the risk department at a big bank? Send your boss a link to this page.
Interest May Accrue During Promo Period –In some cases, the bank keeps track of how much you owe during the promotional period and is accruing the interest you owe based on some amount in the fine print. As long as you pay off the loan before the end of the promotional period, they don’t charge you the interest. But if you don’t pay it off in full, they hit you with it. This is also how most “No interest for X years!” deals at stores work.
Using our $10,000 example above, the fine print may reveal that they are keeping track of your debt with an 18% interest rate. If you don’t pay off the amount in full, you will owe that 18%. If you pay off your loan before the due date, you owe no interest. If you pay it off one day late, you will owe the 18% for life of the loan. For $10,000, that would mean $1,800 of interest. Now you see why they are so willing to lend you this money. Even if several people pay it off in time, a few of you won’t, and they will earn their money. They don’t everyone to falter here, just a few. Don’t be the person that does.
Other Risks – So you know to avoid balance transfer fees and that interest accrues during the life of your loan in case you don’t pay it off during the promo period. What if you lose your job? What if you can’t pay it off before the end of the promo period? What if another “Great Recession” happens and you can’t just transfer your 0% no fee balance transfer to another? These are real risks you need to consider. Are you certain you can pay the debt off in time? If you are using these funds to buy something that you plan to resell, are you sure you can resell it at a price to confidently pay off the debt (like an appreciating car in a normal market, or renovating a house to sell)? If you are using this to invest in stocks, do you know the market won’t crash (you really don’t)?
Conclusion – Used correctly, balanced transfers are powerful. Used incorrectly, and they can at best delay a bad financial situation, or worse, put you deeper into debt.
If you have bad credit and don’t qualify for good balance transfer terms, see my article on balance transfers for debt recovery.