Balance transfers can be a practical and effective way to tackle your credit card debt. Simply, you transfer your high-interest credit card debt to a card with a lower rate. This could be a card with a lower APR, or a card that offers a 0 percent promotional rate on balance transfers for a limited time. (See also: When to Do a Balance Transfer for Credit Card Debt)
This can help your credit score, too. A few weeks ago, I was feeling pretty good about the balance transfer offer I used to move some high-interest credit card debt to a card with a great introductory rate. But, then I realized you have to be careful of your balance transfer strategy. In addition to boosting your credit score, there are a few pitfalls to be aware of.
Pitfall: Applying for a balance transfer generates a hard credit inquiry
If you are trying to boost your credit score, be careful when applying for any new credit cards — including for balance transfers. Each credit application generates a “hard” inquiry on your credit report, which is a negative factor in calculating your credit score. Applying for new credit is considered a risk because it can be a sign of financial distress, especially if you have multiple hard inquiries over a short period of time.
Boost: If used effectively, the balance transfer will eventually raise your score
The drop in score from a hard inquiry is temporary. Unless you are planning on applying for any big loans such as a mortgage, refinance, or car loan, the drop shouldn’t affect you too much. Once you start paying off your balance, your credit utilization ratio will drop. Your credit utilization ratio, which is all of your credit card balances divided by the total of your credit card limits, is a big factor in the “amounts owed” category of your FICO credit score, which accounts for 30 percent of your score. Most experts recommend your credit utilization ratio not exceed 30 percent, and keeping it even lower — under 10 percent — can help raise your score.
Pitfall: Using balance transfers to grow your debt
Balance transfers should be used to consolidate your debt — never to “make room” on other credit cards so you can keep on charging past limits. All this does is rack up more debt.
This can quickly spiral out of control, too. If your debt grows too much, it can increase your credit utilization ratio, which lowers your credit rating. Eventually, taking on too much debt can reach the point where you can no longer make payments on time, and your credit score will take a huge hit. Lenders also consider your debt-to-income ratio when deciding whether to approve or deny you for financing. If your debt becomes too large relative to your income, you may not be able to get approved for any new loans or credit cards.
Boost: A balance transfer can help pay down your debt faster
If you transfer your high-interest credit card debt to a balance transfer card with a lower rate, more of your payment will go toward paying down the principal. Not only will this save you money from interest, but you’ll get rid of your debt faster. Only do a balance transfer if you have a solid debt repayment plan to pay off the balance within the promotion period. (See also: Fastest Way to Pay Off $10K in Credit Card Debt)
Pitfall: Maxing out the balance transfer card you are transferring to
If you get a great introductory interest rate for a balance transfer, you may conclude that you should transfer as much of your high-interest credit card debt as possible to the new card. The problem with this strategy is that you can hurt your credit score by having a high utilization of available credit, even if it is only on one credit account.
Your credit utilization ratio is a major factor in calculating your credit score. Even if you have lots of credit available overall, pushing your balance transfer account near its credit limit can hurt your credit score. The credit utilization metric that contributes to your credit score not only considers overall credit balances compared to your overall credit limit, but also scores utilization of individual credit cards. If you are trying to maximize your credit score, keep your balance under 30 percent of your credit limit on all of your accounts, even after you complete a balance transfer.
Even if the interest rate is great, leave some room on your balance transfer card to avoid getting a lower credit score due to credit utilization.
Boost: Use a personal loan rather than a credit card to refinance debt
Personal loans aren’t counted toward your credit utilization ratio, since a personal loan is not a revolving credit account. However, like credit card debt, the amount you owe on installment loans does figure into the “amounts owed” category of your credit score, though it harms your score much less than a high credit utilization ratio does. In fact, having an installment loan can help boost your “credit mix,” which is a different scoring category that comprises 10 percent of your credit score.
The downside is that you will typically pay higher interest for a personal loan than you would with a balance transfer introductory rate at or near 0 percent. Still, if your credit score is low, or you are trying to boost your credit score to secure the best interest rate you can get on a mortgage, you may want to consider using a personal loan instead of a balance transfer card to refinance your credit card debt. (See also: 5 Times a Personal Loan May Be Better Than Credit Cards)
Check with your bank about a personal loan as an alternative to transferring credit card debt to another credit card if you are trying to improve your credit score.
How much will you really save?
In addition to pitfalls that can lower your credit score, you also need to watch out for pitfalls that can reduce how much money you can save through a balance transfer.
When doing a balance transfer, you’ll typically have to pay a fee between 3 and 5 percent of the transfer amount. The balance transfer fee is charged all at once at the time the transaction is processed, and is often added to your balance on the transfer account. Avoid being dazzled by a great interest rate that distracts you from noticing a higher fee compared with other balance transfer offers. (See also: Best Credit Cards With No Balance Transfer Fees)
The low introductory interest rate that is offered on balance transfers usually expires after 12 to 18 months and is replaced by an interest rate that can be much higher — over 20 percent in some cases. If you can pay off the balance transfer balance before the end of the introductory offer, you don’t need to worry about the higher rate later on. But if you don’t pay off the balance transfer during the introductory offer, you may end up paying higher interest rates than you had on your original credit card.
Balance transfers can be a useful tool to lower your interest rate and help you pay down debt, if you avoid the pitfalls and choose a balance transfer card that makes sense for you.