By Beverly Harzog, author of Confessions of a Credit Junkie
If you’re in credit card debt and you’re paying a lot of interest expense, you probably feel like you’ll never be free of the debt. Hey, I know that feeling. I’ve lived with debt and it’s truly awful. It’s also very depressing to see the effects of compound interest. You keep making payments, but a lot of it just pays for the interest you’re accruing. And your balance never seems to get any smaller.
Well, if you still have good credit, you have an option that could save you a lot of money. You can transfer your debt from a high-interest credit card to a credit card with a zero percent introductory APR on balance transfers. The length of time you’ll get for the intro period will vary by card so you have to read the credit card agreement. But in general, I’m seeing balance transfer credit cards that offer a zero percent introductory APR between six and 18 months.
If you can get a card with an 18-month intro offer, that means you can spend time paying down the balance while paying zero interest. Sound good? Let’s take a look at the details.
How a Balance Transfer Works
Let’s say you have a $7,000 balance on your credit card and you have an 18 percent APR. Yikes, right? It will take you a long time to pay this off. So you apply for a new balance transfer credit card with a zero percent introductory APR for 18 months. After you make the transfer request, your new credit card issuer pays $7,000 to your old bank, which takes your balance down to zero. When the balance transfer is complete, you start making payments on your $7,000 balance, which is now on your new balance transfer credit card.
Balance Transfer Fees
This is a transaction fee that your new bank will charge you for making the balance transfer. It’s generally 3 percent or 4 percent. So in the example we’re using, your fee would be $210 (7,000 x .03). Now, you’re going to save a lot more than $210 with this transfer, so that’s part of the cost of paying down debt this way. When you determine your monthly payment, you’ll take this fee into consideration.
Calculating Your Monthly Payment
Once your transfer is complete, you determine what your monthly payment needs to be to get out of debt in 18 months, if possible. In this example, you’d need to add the transaction fee to your original transfer amount, which makes the total $7,210.
Next, we divide that amount by the number of months in the intro period: 7,210 / 18 = $400.56.
If you can be very self-disciplined and make this payment every single month during the entire 18-month period, you can pay off your debt and save a lot on interest expense. Doesn’t that sound amazing? Paying off your debt might sound like a difficult task, but once you start to see the balance shrinking, you’ll feel like a million bucks. No joke. Momentum will kick in and you’ll be very motivated to keep paying down that balance.
The process for a balance transfer may sound simple, but there are some common mistakes that can derail your journey to financial freedom. These mistakes, by the way, aren’t in any particular order because they’re all bad. So pay attention and make a vow to avoid every mistake on this list. The last thing you want to do is to go through this whole process and end up in worse shape than before. And yes, I’ve seen this happen to folks. These are the seven most common mistakes to avoid:
You Stop Making Payments
This one is entirely avoidable if you pay attention to the details. You have to keep making payments to your old credit card issuer until you get confirmation that the transfer is complete. The issuer for your new balance transfer credit card will tell you when the balance transfer is complete. This means that you will now start making payments to your new issuer. But even then, you should follow up with your old credit card issuer to confirm it on their end. Hey, we’re not done yet! Just to be thorough, you need to check your online account to prove to yourself that it’s zero.
You Don’t Track the Intro Period Expiration Date
Okay, this happens when you don’t make a note of this on your calendar. In fact, make a note of it in as many places as possible. I even recommend checking on your progress every one to three months. There are a variety of high-tech ways to remind yourself. Set up reminders on your smart phone or on your PC or Mac. Or go low tech and get a giant wall calendar to keep track of the date. You can even make a monthly note about your current balance. This has the effect of keeping your balance transfer at the top of your mind. You can see your balance going down as each month goes by. Look, if you don’t pay off your balance, you’ll have to start paying interest on it at the “go-to” rate. The go-to rate is the purchase APR that you’ll pay when the intro rate ends. So stay on top of the date!
You Use Your Balance Transfer Card for New Purchases
This is probably the most common mistake I see. And it’s a deadly one. Once you start making new purchases with your balance transfer card, you’re on a slippery slope to more debt. When you finally land at the bottom of this hill, you’ll still have your old debt. But that’s not all. You’ll also have a fresh layer of new debt on top of the old debt.
Now, sometimes this is the result of a misconception about the intro rate for the balance transfer. I can see how you could mistakenly think that the offer extends to new purchases. And frankly, sometimes the offer does extend to new purchases. But it’s your job right now to get out of debt, not to add to it. Even if you have an intro offer that includes purchases, just tell yourself you can’t buy anything new. Because when the go-to rate kicks in at the end of the intro period, you’ll be paying interest on the whole balance.
Some folks tell themselves it’s okay to use the balance transfer card since you don’t have to pay interest. But life often surprises us with unpleasant news. What if you lose your job? Or your kid needs expensive dental work and you don’t have dental insurance?
If you have an emergency, you might not be able to pay off the new purchases. You know what could happen next? A year later, your intro period ends and the old and new debt have now combined into one big ugly balance. Seriously, you’ll be so mad at yourself if you allow this to happen. Don’t take chances by making new purchases. Stay focused and use this golden opportunity to pay off your debt.
You Don’t Make Payments during the Intro Period
Although you’re getting a zero percent APR for a period of time, it’s not a free lunch. This is like any other credit card balance and you have to make the payments or you’re in default.
When you’re in default, the credit card company can take away your zero percent APR intro period. And guess what? If that happens, you’ll be paying off your debt at the go-to APR. As you can imagine, this wipes out your plan to become debt-free with your balance transfer credit card.
You Make a Late Payment
Some credit card agreements state outright that if you’re late with a payment, you lose the intro rate. Some issuers won’t do this unless you’re over 60 days late. You have to read the fine print to know what the exact terms are for your card. There’s another horrible thing that could happen if you make a late payment. You could get stuck with a penalty rate, which can be as high as 29.99 percent. In addition, you could get hit with a late payment fee.
There are some cards that have done away with the penalty rate, but even if that’s the case, you’d still end up with the go-to APR applied to your balance. As mentioned in Mistake #2, you need to set up a reminder system. You can use email or text reminders so you never forget to pay your bill. Or you can set up an automatic payment in the amount you decided to pay every month to pay the balance off before the intro period ends.
You Assume Cash Advances Are Included in the Intro Rate
I’ve never seen a situation where cash advances have been included in the zero percent offer. This doesn’t mean it will never happen, but it does mean that your default position is to assume that cash advances are not included in the offer. You can get in a mess of trouble when you get cash advances. Cash advances have very high APRs, in most cases. It’s not unusual for a cash advance to have an APR around 24 or 25 percent.
Credit card companies make a ton of money on cash advances. There isn’t a grace period, so the interest clock starts ticking immediately. As soon as the transaction is posted to your account, interest starts accruing. So it’s not surprising that issuers wouldn’t want to cut into that source of revenue. I often tell folks not to get a cash advance unless your life depends on it. It’s way too easy for a simple cash advance to turn into credit card debt. Just don’t go there.
You Close Your Old Credit Card Account
The impact of closing a credit card account depends on a couple of factors. If it’s an account you’ve had for many years, it will eventually have a negative impact on your FICO score. Closed accounts can stay on your credit report for up to 10 years, so the impact won’t happen right away. he bigger issue is something called your “utilization ratio.” When you close a credit card, you lose the available credit (the credit limit) that you had on that card. Here’s an example of how the utilization ratio is calculated:
Let’s say you have two credit cards: Card A, the card with the balance, and Card B, which is your new balance transfer card. Each card has a $5,000 credit limit, for a total of $10,000 of available credit. Card A had a $3,000 balance at a high interest rate, so you opened Card B and transferred the balance to that account.
Your ratio: $3,000 / $10,000 = .30 = 30.0 percent ratio. You should have a ratio that doesn’t exceed 30 percent, so this is close, but acceptable.
If you close Card A, this is your new ratio: $3,000 / $5,000 = .60 = .60 percent, which is unacceptable. This part of your FICO score is no longer optimized, so you might see your score drop. As you pay down your debt, your score will improve because your utilization ratio will go down. But in the meantime, if you’re planning to refinance your mortgage or apply for any kind of loan, this could have a negative impact. A healthy FICO score helps you get lower rates on mortgages, auto loans, health insurance, life insurance, and auto insurance.
Unless you have a problem with compulsive spending, I recommend keeping the old account open. But hey, if you do have a problem with spending and that’s how you got into trouble in the first place, then do what you need to do to stay out of debt. Credit cards can be a valuable financial tool if used responsibly, but they aren’t for everyone.
Beverly Harzog, credit card expert and author of Confessions of a Credit Junkie: Everything You Need to Know to Avoid the Mistakes I Made.