Wednesday, November 25, 2009

Credit Card Balance Transfers - A good deal or not?

If you're drowning in debt, is a balance transfer throwing you a life ring or an anchor?

If you find yourself in a pile of debt, or with a high balance on a credit card with a high interest rate, the Credit Card balance transfer may look appealing. In this current economy, people are finding themselves in a pinch, financially, and credit card balance transfer offers look awfully appealing as a way out of trouble.

Should you transfer high balance and high interest debt to a credit card? In most cases, the answer is NO. In some situations, they may provide temporary relief. But if not handled properly, they can end up throwing gasoline on the fire of debt, or merely transfer perpetual debt to a new provider.

There are many things you should be aware of before attempting such transfers.

To begin with, it is wholeheartedly foolish to transfer ordinary debt at a low interest rate (or no interest rate) to a credit card to "consolidate debt" or some such nonsense. The idea that keeping track of multiple debts is somehow "difficult" is nonsense, particularly in this computer age. If you have debts that have no effective interest or low interest rates, it is smarter to just pay these off than to waste time and money "consolidating" debts for convenience only.

If you owe money to a creditor who does not charge interest, then it makes more sense to pay them off in monthly installments than to put that debt on a credit card. For example, we had an unexpected $1200 medical bill for a CAT scan. Rather than put that on a credit card and make payments for years (and pay nearly twice the debt in interest) a simple call to the medical care provider was all that was needed to pay off the debt in six monthly payments of $200 each. If you are hard up for cash, by the way, it never hurts to ask for a discount as well. Medical bills, like legal bills, are highly elastic.

But let's assume you have $5000 in debt, on a credit card or other high-interest loan, such as 15% or more (some can go as high as 30%!). Does it make sense to transfer this to a credit card with a "zero percent balance transfer"? Before you make a decision, understand the benefits and the pitfalls.

The pitfalls are numerous:

1. Transfer fee: Usually the credit card company charges you a transfer fee of 3-7% of the balance. For a $5000 debit, at 5%, this could be $250 right off the bat. Of course, if you left the money in the old account, you'd accrue at least $750 in annual interest charges, so even with the transfer fee, you might end up saving money in interest - provided you don't accrue other interest payments.

2. Base Rate after Trial Period: Usually these zero percent (or reduced percentage rate) transfer offers are only good for a period from six to twelve months. After that, the interest rate on the balance may go up to another amount. If this default amount is higher than your existing rate, or close enough to it (taking into account the transfer fee), it makes no sense to transfer a balance. Note that some cards (Discover, for example) will keep your balance transfer at 0% provided you use the card for new purchases (e.g., twice a month, or a minimum purchase) but there is a catch to that as well, as we shall see.

3. Purchase Rate on New Purchases: If the purchase rate on new purchases is high, you can end up paying more interest over time if you use the card for new purchases, due to the nature of revolving credit. For example, suppose you "roll over" the $5000 into a zero percent interest transfer on a new card with a 10% interest rate. You make a $200 a month payment on the card, but you use the card to make $100 a month in charges to restaurants, gas stations, etc. Each monthly payment is applied to the balance transfer FIRST, and the new charges on your card accumulate interest at 10% every month (every day, actually, but that's more complicated that we need discuss here). Until you pay off that $5000 balance transfer, not a penny of new purchases is paid for.

Thus, in our example, if you pay $420 a month on this $5000 "12 months interest-free" balance transfer, you will pay off the balance transfer in 12 months.  If you don;t, you owe interest on the original $5000 going back to the date of the balance transfer.  In the meantime, you have accumulated $2500 in new debt, that each month accumulates 10% interest over those same 12 months.   If you owe even a penny after those 12 months have elapsed, even if it is "new" debt, you owe interest on that five grand going back a year.  Pretty soon you may be back where you started - with a credit card with a perpetual balance with a fairly high interest rate.

Understanding the nature of revolving credit, you now understand why Discover and others want you to USE the card for new charges, as each new charge gets piled onto the top of the payment list, and is paid off last, with the most interest accumulated.

The transfer fees, interest rates and other terms will vary from lender to lender. The better your credit history is, the better the terms you will be able to negotiate.

Using balance transfers is like juggling hand grenades. It can be done, but it is tricky and if you drop one, well, bad things will happen. A balance transfer can make sense under certain limited conditions:

1. You have a super high interest rate credit card: If you find yourself paying 25% interest or more, it may be nearly impossible to ever get out from under such debt. You will pay more in interest than you do in loan balance. In these situations, even with transfer fees, you may do better with a balance transfer.

2. The balance transfer is for 0% or low rate (2.9%) for the life of the balance or a long time: A balance transfer that provides interest relief for only a few months is usually no bargain, as it does little to reduce your interest debt load. Negotiate for the longest period possible and also contact multiple credit card agencies.

3. The baseline interest rate is low: If the regular purchase rate on the card is high, or the standard rate (that the balance transfer will default to after the trial period) is high, you are no better off than before. If your credit rating is good, you should be able to get an interest rate below the current average rates - preferably something under 10% at the time of this writing.

4. You do not make purchases (or many purchases) on the card: As noted above, some cards will keep the transfer rate at 0% provided you make additional purchases. If you limit those additional purchases to just enough to keep the transfer rate at 0%, then this could be a strategic move, provided the purchase APR is low or reasonable. Otherwise, you will end up racking up more debt at high rate and be back where you started.

5. You have a PLAN to get rid of the debt, not perpetuate it: The Credit Card companies are not your friend, and they want you to keep increasing your debt load (or at least maintaining it) over time. It takes some time to get into debt, and getting out of it is not easy. If you are using a balance transfer, it should be part of a strategic plan to pay down your debt over time with the idea of being debt-free as the achievable goal.

6. You setup AUTOPAY on your account: If you do not make the minimum monthly payment on your accounts by the due date, your interest rate may skyrocket on your new account. It pays to setup an autopay on your account so the minimum monthly payment is made to your account every month on time. Otherwise, if a payment is lost in the mail, or you forget to make a payment - even for one month, you will end up being "late" on a payment and the "default" interest rate (usually 25% or more) will kick in.

Credit Card companies prey upon human weaknesses - the urges we have to have something now and pay for it later. They also prey upon our weakness to be lazy about money and not pay attention to payment due dates, etc.

When you get a credit card, you are playing a game where they write the rules, and all the rules are not in your favor. Balance transfers are particularly tricky, and if not monitored closely, can end up leaving you worse off than where you were before.

If you have good credit, paying off a debt through other means may be a better approach. However, paying off one loan with another is often a process fraught with peril. As I noted in an earlier post, one reason the country is in the trouble it is in, is that many folks in the 1990's and 2000's ran up credit card debt and then used home equity loans to pay it off. They went out and ran up more credit card debt again, and repeated the process until there was no equity left in their homes.

As I will discuss in my next posting, being DEBT-FREE is a better approach to financial health over the long term.