How Do Balance Transfers Work?
If you can't pay your credit card bills, a balance transfer may buy you some time to get your finances sorted. A balance transfer may save you a lot on interest and help consolidate your debt. However, there are a few things that you need to know before signing up. Here's what you need to know about how balance transfers work.
What is a Balance Transfer?
A balance transfer is when you transfer debt from one or more credit cards to another credit card with a lower interest rate. People usually opt for a balance transfer when their bill enters the late payment stage, right before their outstanding balance is charged a high-interest rate and late payment penalties.
A balance transfer with 0% interest is typically only for borrowers with good to excellent credit.
How does a Balance Transfer Work?
Let's say you have a Chase credit card with a S$1,000 debt at 26.9% APR. You take out a DBS credit card that has a S$5,000 credit limit with 0% APR for one year on balance transfers. Afterward, the interest rate returns to 28% APR.
By doing this balance transfer, DBS pays off your Chase debt. The balance of S$1,000 is moved from your Chase account to your DBS account. There is a 3% administrative fee, or S$30 charge. The new balance on your DBS account is S$1,030. You have one year to pay off this balance, as opposed to facing the immediate 26.9% interest rate on the old credit card.
This extra time can still save you hundreds of dollars in interest, even if you can only afford to pay the minimum payment, and nothing more. If you stayed with your Chase credit card and made the minimum payment of S$32.19, it would take you 124 months to pay off your debt. In that time, you would have paid S$1,226.19 in interest and fees.
On the other hand, if you did a balance transfer to the DBS credit card, the ideal situation is that you could pay off the entire balance in a year and pay S$0 in interest and fees. Worst case scenario, if you could only afford the minimum payment of S$33.33, it would take you 38 months to pay off your debt. In that time, you would have paid S$237.73 in interest and fees. You save money even though this card has a higher APR than the first card!
What are the Benefits of a Balance Transfer?
A balance transfer is usually advertised with 0% interest. With no interest, whatever you have charged is what you will end up repaying. You may have to pay a one-time administrative fee, but this is likely less than what you would spend on interest on the current credit or if you took out a personal loan instead.
Consolidating numerous debts into a balance transfer is possible. These debts include loans and other monthly installments, as well as other outstanding credit card balances. As a result, with one single low-interest credit card, you can now focus on paying down one debt instead of managing multiple minimum payments.
Unlike a personal loan with a fixed monthly installment, a balance transfer only requires you to pay the minimum payment each month. The minimum amount can range from 1% to 3% of the outstanding balance. In essence, you decide how much you can afford to pay. Remember, the goal is to pay off the entire debt before the balance transfer tenure is up. If you need a few months to get on your feet, to find a new job, for example, a balance transfer is ideal. You can pay the minimum, and when income starts coming in, you can pay down the debt as fast as you can.
What do I Need to Watch Out For?
The sum of your transferred balances cannot exceed the transfer limit that you have been approved for. Some credit card issuers cap the amount that you can transfer proportionate to your credit limit. Your credit limit is a maximum amount of four times your monthly salary. After approval, you will be able to find out how much you can transfer.
Fees Are Unavoidable
In general, fees are inevitable. Most credit cards charge a one-time administrative fee, also known as a balance transfer fee, which is a percentage of the total amount that is being transferred. Most cards have a 3% charge. For example, if you need to transfer S$10,000, S$300 will be added to your total balance because of the 3% fee.
No Administrative Fee Means Less Time to Pay
Some credit cards advertise a 0% administrative fee, but they usually have a shorter 0% interest rate period. As a result, if you don't pay off the entire balance within that time, you will quickly need to repeat the process all over again with another balance transfer. You will be stuck in a balance transfer black hole.
This constant cycle of transferring your debt can ruin your credit score. Every time you open an account, you authorize a hard inquiry into your credit history. Each inquiry lowers your score a little. Furthermore, lenders can see that you frequently open low-interest accounts but sustain high debt levels. You will find it more and more difficult to qualify for each new credit card and ruin your chances to take out loans in the future.
You are Transferring Debt, Not Repaying Debt
Remember, you are transferring debt, not repaying. You have bought yourself some time, but the principal amount that you owe will remain the same, plus an administrative fee. The only actual benefit to using this method to help save money is if you pay back what you owe at a lower interest rate. Be sure to weigh the balance transfer fee against your late payment fees to see if it makes financial sense.
Promotional Low-Interest Rate Period
With that said, be sure to read the fine print. Some credit cards have a promotional balance transfer interest rate. This temporary extra-low annual percentage rate (APR) is to entice you. However, after some time, such as six months, the interest rate will increase. In fact, the regular interest rate may be higher than your first credit card. Always allow yourself enough time to pay off your debt during the low-interest rate period or you may end up with even more debt than before.
Transfer Balance Debt Versus New Debt
Some balance transfer credit cards have rules that separate balance transfer debt and new purchases. Your balance transfer may have 0% interest, but any new debt you accumulate may be subject to the regular APR. If this is the case, don't use your card anymore! Pay the debt every month without adding new transactions. It doesn't make fiscal sense to add new debt at a high-interest rate while you are trying to eliminate existing debt at a low-interest rate.
What Should You do with Your Old Card?
Once your old card is balance free, you may wonder what you should do with it. Obviously, you don't want to run up more debt. However, you don't necessarily need to close your account. Having open lines of credit on your credit report can help your credit score. As a result, you may consider leaving it open with a S$0 balance. If your old card has an annual fee, then you may consider closing it. There is no reason to pay for a credit card that you are not using.
A balance transfer is only a temporary solution. If you find yourself doing this frequently, it may be time to reassess your spending habits. This interim remedy is only beneficial if you can pay off the original debt, plus the fee, during the transfer balance tenure. It is advisable to calculate if this method will save you money, if you can afford the minimum payment, and if your budget allows you to pay off the debt in the allotted amount of time. Use a balance transfer wisely to help you get back on your feet.