Is a balance transfer worth it?
Balance transfers can be an effective way to pay down debt. But they shouldn't be used as a way to delay payment.
In the last few years, I've received a lot of questions about balance transfers from people looking for an edge in battling their credit card debt.
A few years ago, most cards with balance transfers didn't have a transfer fee and, with comparable post-promotional interest rates, the transfer itself was an easy "yes." A 12-month 0% period meant a borrower got a full year to catch up on their debt, as long as they didn't accumulate more.
Nowadays, with balance-transfer fees and less favorable post-promo rates, the decision isn't as obvious. Fortunately, I believe a quick back-of-the-envelope calculation is enough to help you decide whether a balance transfer makes sense financially for you. We will have to ignore the credit score implications of applying for a new credit card for the balance transfer, because it's difficult to definitively quantify the impact of a hard inquiry (though we estimate a new credit card costs about 14 points).
Also, before we get into the meat of the post, I want to make the point that you shouldn't approach a balance transfer as a way to delay payment. It can be used that way, but it's most effective as a tool for paying down your debt. You can't balance transfer your way indefinitely anymore. The credit crisis made sure of that.
Four horsemen of balance transfers
There are four numbers you need to know when calculating whether a balance transfer is worth it:
- Your current card's interest rate.
- Your new card's promotional balance-transfer fee (the percentage rate, plus the minimum and maximum dollar amounts if applicable).
- Your new card's promotional interest rate and length.
- Your new card's regular, post-promotion interest rate.
From here, you have to determine which scenario you fall within:
- Can pay off within promotional period.
- Cannot pay off within promotional period.
Can pay off debt
If you can pay off the debt within the promotional period -- remember to account for the balance-transfer fee -- the balance transfer is usually a safe bet if you get relief on the interest rate. As long as your current interest rate is higher than the balance-transfer fee plus the promotional interest rate, it makes sense for you to consider the balance transfer.
Cannot pay off debt
The math becomes a little trickier if you cannot pay off the debt within the promotional period because now you have to consider the impact of the post-promotional annual percentage rate.
First, determine your effective promotional interest rate by converting the balance-transfer fee into an APR. If the promotional period is 12 months, then you don't have to do any math because the balance-transfer fee percentage is the "APR" contribution of the fee. Take that and add it to the promotional APR, which hopefully is 0%. This gives you your effective APR over the period (it's technically a little higher because the fee is assessed all at once, rather than over the period, but this is close enough).
If the effective promotional interest rate is higher than your current interest rate, you will want to pass (this is a no-brainer -- you're trying to save money here). If it is lower, as it should be, set your sights on the post-promotional interest rate and compare it with your current interest rate. If it's lower, then it's a no-brainer because you're paying less during the promotion and less afterward too. If it's higher, you have to calculate whether or not you'll get ahead by taking the temporary interest rate relief.
Let's take an example of the most complicated case: You have a $10,000 credit card debt at 15% and you are able to make, at most, $500 monthly payments. You read a promotional offer of a 0% balance transfer with a 3% fee and an interest rate of 20% after the promotion.
After 12 months, here's what it would look like (you can use this calculator):
- Took transfer: If you took the transfer, your balance would be $3,800.
- No transfer: If you didn't take the transfer, your balance would be $5,117.
It's obvious so far that taking the transfer makes sense: 12 months of 0% gives you a lot of time to catch up even if you have to pay an extra $300 (3% on $10,000) at the start.
From here, how long will it take to pay off the debt?
- Took transfer: $3,800 at 20% interest takes eight to nine months to pay off.
- No transfer: $5,117 at 15% interest takes a little more than 11 months to pay off.
In the above case, you come out three months ahead if you take the balance transfer even though the post-promotional rate is 5 percentage points higher.
The moral of the story is that you need to do the math -- there are plenty of calculators online -- to know for sure whether or not it makes sense. In my example, I think my gut feeling would be that you should not take the transfer, but the math shows you come out three months ahead.
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