Credit Card Balance Transfer
If you have a high-interest credit card, it may be enticing to transfer the balance to a credit card with a lower interest rate or a card offering a 0% introductory rate. It is easy to compare the interest rates charged by each card using the annual percentage rate (APR); however, the decision is not as simple as choosing the lowest APR. There are other considerations to keep in mind, such as the transfer fee and the time required to pay off the balance.
Important Factors to Consider Before a Balance Transfer
- Annual percentage rate (APR)
- Balance transfer fee
- Size of the balance
- Monthly payment amount
- Time required to pay off the balance
- Opening a new credit card for an introductory APR
What is APR?
APR is the yearly interest rate paid on your credit card balance, as well as any additional fees. While typically close to the interest rate charged by the card, the APR can vary slightly due to the inclusion of other fees. Consequently, the APR and interest rate are not always the same. Interest is only paid if you carry a balance from one month to the next. If the statement balance is paid off within the billing cycle, then you are not charged any interest. To calculate the interest owed from carrying a balance on the card, you will take the APR and divide it by 365 (the number of days in the year). For example, if your interest rate is 19.99%, then the daily rate is 0.05477%. Typically, the interest will be compounded daily, meaning you pay interest on the interest charged the day before. For example, if you have a $5,000 credit card balance, one day of interest is $2.73 ($5,000 multiplied by .0005477). The second day, the interest would be charged on $5,002.73, making that day’s interest $2.74. Compounding is powerful, so when it is working against you, as in the case of credit card interest, you want to eliminate it as soon as possible. APR is an important factor to consider before opting for a balance transfer, but you also must consider the balance transfer fee.
What is a balance transfer fee?
When you conduct a balance transfer from one credit card to another, the card to which the balance is transferred will assess a balance transfer fee. This fee is typically close to 3%, so the larger the balance you are transferring, the more you will be charged as a balance transfer fee. If the amount transferred is $5,000, and the credit card you are transferring it to has a 3% balance transfer fee, then your balance on the new card will be $5,150. All other factors being equal, a lower balance transfer fee is more desirable.
How long will it take to pay off the credit card balance?
Once you assess the differences in APR between your current card and the one you are looking to transfer the balance to, as well as determine the balance transfer fee that will be charged, you need to consider how long it will take to pay off the balance. Credit card providers are required by the Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (Card Act) to disclose how long it will take to pay off the balance of your card if you only pay the minimum balance. However, paying the minimum balance is one of the biggest credit card mistakes. Instead, you should make the highest payments that your budget can accommodate to pay off the balance as quickly as possible and eliminate your monthly interest payments. Once the looming credit card debt is no longer hanging over your head, you will be amazed at your increased ability to save and invest for the future.
Since paying the minimum balance is a bad option, you need to determine how much you can afford. Then you will need to determine how long it will take to pay off the balance if you continue to pay that amount each month. For example, assuming you plan to pay $500 per month towards your balance of $5,000, you must reduce the balance by your monthly payment amount and calculate the interest on the remaining balance. In this scenario, your $5,000 balance at 19.99% APR would take 12 months to pay off, and you would pay $515 in interest. To determine if a balance transfer is beneficial, you need to compare the interest you would pay on your existing card against the balance transfer fee and APR on the new card. If you are transferring the $5,000 balance to a card with 0% APR for 18 months with a 3% balance transfer fee, then you would save $365 by transferring the balance. You can calculate this by subtracting the balance transfer fee of $150 from $515, the interest you would have paid on your current card over the 12-month period. Therefore, in this instance, a balance transfer may be desirable. However, if you can make more aggressive payments and pay the balance down faster, then the balance transfer fee may outweigh the benefit obtained from not paying interest.
Is it worth opening a new credit card?
Obtaining a 0% APR is typically only possible when you open a new credit card and receive this rate as a time-limited introductory offer, such as 18 months at 0%. If you do not desire to open a new card, then you would simply be transferring the existing balance to another card with a lower APR. In this case, the balance transfer fee can often offset the benefits obtained from the lower interest rate. For example, transferring your $5,000 balance from a credit card charging 19.99% APR to a card charging 14.99% APR and paying $500 per month would result in paying $375 in interest. Once you add the $150 balance transfer fee, your total cost is $525. When you compare this amount to $515, the amount of interest you would have paid by leaving the balance on the original card at 19.99%, you can see that you paid $10 more by transferring the balance to your card with a 14.99 APR. In this case, you should have left the balance on your original card.
As you can see, having a 0% APR can make a considerable difference in the total amount you will pay for a balance transfer. However, depending on your current credit score and the number of credit cards you already have, it may be difficult or undesirable to open a new account. It may be tempting to open the account to obtain the lower APR and close the account once you pay off the balance, but you need to consider the impact on your credit score. A hard credit inquiry, which is conducted when you apply for the new card, will result in a drop in your score albeit this is one of the less impactful factors influencing your credit score. Additionally, closing the account will impact credit, as it will lower your credit limit. However, given that your cumulative credit limit (between all your credit cards) will be the same as it was before opening the card and your credit card utilization rate will be lower after paying off the balance, the impact on your credit score should be minimal.
Conclusion
Before rushing to take advantage of a credit card balance transfer offer, ensure you evaluate all the relevant factors. Some items you will need to take into consideration are the balance transfer fee, the APR on the new card, the amount you can afford to make in monthly payments, and the time it will take to pay off the balance. After reviewing all these considerations, it is possible to determine if you will pay less in interest by leaving the balance on your existing card or transferring it to a card with a lower rate. While you can transfer the balance to one of your other existing credit cards, the best balance transfer APRs are typically only obtained by opening a new credit card, so you need to consider if the benefits of opening a new card are substantial enough to warrant the balance transfer.
