What You Must Know Before Using a Balance Transfer to Consolidate Debt
A sure sign that the economy and credit card lending are picking up, is when people begin asking questions about balance transfers, debt consolidation plans and home equity loans. Recently, a client asked us about the best method for paying off credit card debt.
This is a great question and one that has multiple answers. The option you select has to fit within your budget as well as help you achieve your financial goals. Today we will look at one option – the balance transfer. In a balance transfer, you transfer the balances of each of your credit cards onto another credit card account. The other credit account typically promises low or zero interest on balance transfers for a specific period of time. You should know the following before you complete a balance transfer.
This option requires that you have decent-to-good credit (probably a credit score of at least 675), you do not have late payments on your credit report in the last 12 months, and your debt-to-income (DTI) ratio is less than 40%. See our article How to Know What You Can Afford in a Home, for more on DTI ratios.
Balance transfer fee
In addition to the positive credit aspect, you need to find a credit card that will give you a limit large enough to transfer the balances. You may be assessed a balance transfer fee for paying the old credit cards off using the new card. Balance transfer fees typically range from 3% to 5% of the transferred balance. This will add to the amount you must repay. For example, if you transferred a balance of $10,000 to a new credit card and that card had a balance transfer fee of 4%, the fee would equal $400.00. That is money you could be putting toward your debt.
Interest on the new account
Another consideration is the interest rate on the new account. The best case scenario is that the card will have 0% interest on transferred balances. Sometimes this interest rate is for “life,” but more commonly it is for a specific time period and is valid as long as you stick to the plan. You have to make your payments on time and if you use the card for purchases, know that your payments will be applied to the amount with the highest interest FIRST. If you pay the transferred balance off according to the agreement, you will not have to pay interest.
Zero balance credit card syndrome
The next step to tackle is how to handle the credit card that is paid off in the transfer. Should you close it, leave a small balance on it and make payments, or use it sparingly and always pay it off in full? We know that closing a credit card account can impact your credit score in a few ways. It can:
- Reduce the average length of time you have had open credit accounts
- Reduce your overall available credit, thus increasing your credit usage ratio
Closing original cards, after paying their balances in a transfer, can really deflate your credit score. The key in this situation may be to keep one card (the oldest) open and set up an automatic payment. Use the card to pay for something you always budget for, such as a Netflix or a utility account. Use the card to pay the recurring bill and then set your bank account to pay the card, in full, every month.
The danger to your finances from a balance transfer, is using a card as you did in the past. Rather than paying off the balance transfer card, people will often end up with a balance on both their old and new cards, which increases the amount of debt they owe.
If you are in the market to consolidate your credit cards, think about what it is you are trying to achieve. If your overall goal is to get out of debt, this may work. If you are already struggling to make payments on time or are already making late payments, this may not be the strategy for you. Remember, late payments may increase your interest rate above the balance transfer rate.
Also, closing or opening credit cards close to the time you are going to purchase a home may cause problems for you during the home loan process. If this applies to you, be sure you talk to your lender before making any financial moves that may impact your credit.
Finally, there are great research sites such as Bankrate.com and Nerdwallet.com. Through these sites, you can compare credit cards and explore the cost of balance transfers.
Looking for more information on strategies for getting out of debt? Call or chat with a counselor now! 1-888-818-5037
Published Apr 16, 2015.