A Good Time to “Zero In” on Debt Reduction?
Stamped in big bold letters on the envelope, the phrase “ZERO INTEREST” or “PAY 0%” catches your attention. You have just received a “teaser” from a credit-card company, an offer to transfer an existing card balance to a new lender, and have zero interest applied to that balance for a specified period.
You may be receiving a lot of these offers in the near future. Hungry to attract new customers in a time when many American households are reducing their discretionary borrowing, an August 27, 2013 Wall Street Journal article reports “Financial companies that issue plastic are flooding mailboxes and email accounts with offers that allow new customers to transfer their existing credit-card balances from other institutions without paying interest for as long as two years.” These offers, known as 0% balance transfers, are used “to reel in new customers with the lure of not paying interest on current balances, and then get them to rack up interest-bearing charges on new purchases.”
Depending on your financial circumstances and habits, a 0% balance transfer may represent a great opportunity to reduce the costs of previous borrowing decisions, and speed up your transition to better financial footing. Having clear objectives and guidelines can make this happen, but remember: the credit-card company’s objective in offering the 0% balance transfer is to acquire another customer who “racks up interest-bearing charges on new purchases.”
Here are some issues and strategies commonly considered in conjunction with a 0% balance transfer:
Understand the transaction costs. Most credit-card institutions impose a transaction fee on balance transfers, typically 3% of the amount transferred. If in return you receive 12 months of interest-free payments, the net cost of the transaction is 3%. This rate is probably lower than the monthly interest applied to an existing card account, but remember: a 0% balance transfer is not “free.”
Examine several offers, including those from existing accounts. As mentioned in the WSJ article, 0% balance transfer offers may vary significantly as to the length of the interest-free period, the rates for new purchases, and how unpaid balances are treated at the end of the period. Further, if you ask, your current card company may offer new, more favorable terms to keep the account in their portfolio.
Applying for an additional credit-card account may affect your credit report. Potential lenders are concerned not only about your current debt, but how much unsecured debt you have the authorization to accumulate. If you have one card with a $30,000 limit, and another lender offers a card with a $20,000 limit to transfer a $10,000 balance (remember, they want you to spend more with the new card), your potential debt limit has risen by $10,000, which may trigger an alert from the credit reporting agencies. Conversely, closing old accounts with strong payment histories as a way to lower total credit limits may also have a short-term negative impact on your credit score until the new accounts “age” well.
Make timely payments. Many 0%-interest offers are invalidated by late payments; if this happens, interest begins accruing at the card’s regular rate on the next billing cycle – a rate which may be higher than the card from which you transferred the balance.
Do not use the new card. Treat the new account as an unsecured loan for a specific amount, and do not commingle the balance with any transactions that will incur interest charges. Commingling current transactions with old debt makes it hard to segregate payments. In addition, keeping the new account dormant is psychological reinforcement that the purpose of the transfer is debt reduction, not spending at a lower cost.
Establish a regular payment schedule. As the balance decreases, the monthly statement will reflect a lower minimum monthly payment. But the goal is not lowering monthly debt service payment, it is clearing old, unproductive debt in a cost-effective manner. Keep your payment fixed.
If you don’t expect to pay the balance in full by the time the 0% - interest period expires, have a Plan B. As mentioned earlier, the standard interest rate after the teaser expires may be higher than what is currently being paid on existing accounts. Paying 20% interest in years 2 and 3 after 0% - interest in year 1 may be more costly than continuing to pay off a current account at 12%. Some consumers might anticipate making another 0% - interest balance transfer when the first expires, but future offers are not guaranteed.
The Key Ingredient
Beyond the financial considerations involved in deciding to accept a 0% balance transfer, there is a critical psychological component: You must have the discipline to use the offer to your advantage in accelerating debt reduction. It is easy for spendthrift consumers to see no interest charges and lower payments as a way to increase their spending (which is precisely what the credit card company intends). Instead of accelerating payoffs, they end up with even more debt – often at higher rates.
Credit card companies make 0% balance transfers an easy do-it-yourself project. But because of the details involved, many consumers would benefit from a second opinion from a financial professional familiar with their unique circumstances.