Some things sound great on paper and end up being just as great in real life, like bacon-wrapped shrimp and blankets with sleeves.
Other things, however, may sound great in theory, but simply don’t work the way you thought they would, like Crystal Pepsi or a theme park filled with real dinosaurs.
Debt consolidation sounds like a sure winner on paper, but every variety of consolidation carries certain risks, and balance transfers, in many ways, are the Jurassic Park of financial solutions – if everything goes just right, they can be a great way to save money and pay down debt quickly.
But how often does everything go just right?
What is a balance transfer?
Balance transfers are simply the act of moving a debt (usually unsecured credit card debt) from one account to another, most often with a 0% interest rate as the primary enticement. They’re a popular form of debt consolidation, because consumers benefit from the reduced APR (annual percentage rate), saving money on interest charges and paying down debt faster as a result.
Sounds good, right?
What could go wrong?
Cue the Velociraptors!
First, most credit card companies now charge a transfer fee, generally in the vicinity of 3% to 5% of the total balance. Try to consider how quickly you plan on paying off the debt in order to make sure that the fee you’re paying is less than the amount of interest you’ll end up saving.
Second, you have to bear in mind that the 0% rate is generally for a limited period of time (usually between 3 and 18 months). Are you going to have the entire debt paid off before the rate expires? If not, prepare for your APR to go up, potentially all the way to the maximum allowed.
Also, some 0% promotions are actually deferred interest promotions, which means that if you don’t have the full balance paid off at the end of the set term, you’ll be on the hook for all of the interest that accrued during the life of the promotion (which could be substantial).
Another thing to keep in mind – that rate is almost always contingent on making on-time payments every single month. If you miss one payment you’ll find yourself back at that high interest rate, not saving any money at all!
The state of your rate
A mistake consumers often make with these new credit cards is using them to make new purchases.
Consumers will often roll all of their pre-existing credit card debt into a new card, meaning the old accounts are closed and therefore no longer available to use. This means that if they need to use credit, they go straight to the newly open account. The problem is that the 0% APR usually only applies to the balance transfer – new purchases are subject to interest charges.
On top of that, credit card companies are free to apply your monthly minimum payment towards whichever balance they choose – and they almost always choose the portion of the balance with 0% interest. All of which means that your new purchases are accruing interest every month, while the balance on those purchases isn’t going down at all!
(It’s important to note, thanks to the CARD Act of 2009, that credit card companies are now required to put the portion of your payment that's beyond the minimum amount due toward the balance with the highest APR.)
How your credit score factors in
One of the factors (and there are many) of calculating your credit score is the length of time your accounts have been open – the older your accounts, the better that is for your score.
When you roll all of your balances into one new card, the old accounts are closed, and instead of having multiple old accounts, you now have one brand new account, which could have an enormous impact on your credit score.
What are your alternatives?
If you’re looking for a reduced interest rate and the ease of a single consolidated payment, debt management might be a better option for you.
For consumers who qualify for debt repayment through a Debt Management Plan, the lower interest rate is generally fixed for the life of the debt and in most cases won’t default for a single missed payment.
Also, Debt Management Plans are designed to fit within your budget and have you debt-free in 4 to 5 years!
Consult with one of MMI’s certified credit counselors today to see if a Debt Management Plan is right for you!