As our team has been working with our clients, we've noticed that more and more people are carrying a credit card balance. This inspired me to look into why we were seeing this type of financial behavior and what solutions we could offer to help.
Before I start, I want to put things into perspective. An article from The Motley Fool’s editorial section1 noted that the average American credit card debt is $5,221. Granted, this figure doesn’t mean much by itself. It just means people are spending more than they make. Now, add the fact that the average credit card interest rate or annal percentage rate (APR) was “16.44% as of November 2021, according to data from the Federal Reserve2”, the outlook on the American citizen’s balance sheet isn’t looking too appealing. This means that as Americans continue to hold a balance on their credit cards, they will continue to pay interest on them. Currently, with the Federal Reserve looking to increase the federal funds rate to combat inflation, this would cause the prime rate, which is the interest rate that banks charge their largest customers, to increase. As the prime rate increases, credit card rates usually do too. This will cause those who carry balances to pay more interest and to take longer to pay off their balances.
One possible solution that could help those who carry a balance is a credit card balance transfer. This is the process of opening up a new credit card that offers a year or more of 0% APR and then transferring your existing credit card balance to the new card. There are a number of benefits and disadvantages that come into play when considering a credit card balance transfer. In this blog post, we will review these pros and cons of this strategy.
Pros Of Doing A Credit Card Balance Transfer
Taking Advantage of a Lower Credit Card Interest Rate
The lower rate will be beneficial if all of the other credit cards in your wallet have high interest rates. Since you’ll have a lower rate and possibly no finances charges, more of the monthly payment will go to reducing the principal debt instead of going towards interest. With a game plan to pay off the balance during the promotional period of 0% APR and monthly payments, you may even be able to pay off your balance completely by the time the promotional period ends.
Consolidation
A review of national credit report data shows Americans held an average of 3.84 credit card accounts in the third quarter (Q3) of 2020, according to Experian data3. Let’s round that to an even 4 credit card accounts. Now, if a person is carrying a balance on multiple credit cards to average around the $5,221 figure I mentioned above, it can feel daunting to try and pay off each one. By consolidating all debt into a single card (given it has a high enough credit limit), it can be easier to stay on track and pay down your balance.
Cons Of Doing A Credit Card Balance Transfer
Short Term Reduction in Credit Score
Applying for a new credit card account can affect your credit score. Also, your credit score will decrease anytime you have a credit card with a balance that is over 30% of the credit limit. This is due the the fact that the credit utilization ratio is higher than the recommended 30%. The goal is to keep it under 30% for all cards. The good news is that you can increase your credit score slowly as you pay off the balance with timely payments on a monthly basis.
Risk of More Debt
It will feel great to move you existing debt to a new credit card and pay little to no interest during the promotional period. This will in turn free up the credit limits on your existing credit cards you have and if you are not disciplined, you can fall into the same trap of spending more that what you can pay off, leaving you more in debt.
Factors To Consider
Will it save you money?
For those who might have a smaller balance that will still take an extra month or 2 to pay off, it might be advantageous to not open a new credit card and pay the balance transfer fees (usually 3% of the balance being transferred). You will also save yourself the work needed to open and ensure balances can transfer.
Is your current credit score enough to open a credit card?
When opening up any line of credit with an issuer, they will look into one or multiple credit scores with the main 3 credit bureaus (Experian, Equifax, and TransUnion). For those who have a lower credit score under 630, it may not be possible to open a credit card as the issuer may deem you a risk. Click here to check out this great article from NerdWallet to learn more about credit score and credit score ranges.
Will you qualify for the promotional 0% interest rate?
As you apply for the card, the issuer will determine if they will offer you the promotional 0% interest rate. So, it is not a guarantee that you can qualified as you typically need a decent credit score.
Are you looking to buy a home or car within a year?
When opening up a credit card, as mentioned above in the Disadvantages section, your credit score will drop a number of points. Depending on your own credit history, this could be a nominal number or a significant number. When buying a home, mortgage lenders do extensive research into the borrower’s finances which include verifying employment and income, reviewing assets, reviewing credit reports, checking credit scores, and calculating your debt-to-income ratio. A new credit card application could interfere with the process as it effects 2 of the 5 aspects mentioned above. Also, lower credit scores will lead to higher interest rates that can cost thousands over the life time of the mortgage loan.
I hope this month’s blog post gives you a bit of insight on credit card balance transfers and how they can be a resource for those in debt, but also a catalyst for even more trouble if not disciplined. If you are still unsure how credit card balance transfers can work in your current financial situation, I highly recommend you to schedule a consultation with Tori or Alex.
Best,
Brandon