Low-interest balance transfers and debt consolidation can be tempting. Learn how to determine if a balance transfer or debt consolidation is right for you.
Interest rates are super low right now. So, you may be tempted to shop for deals and move your debt around. Before you do, you need to know how to determine if refinancing your personal debt is a good idea. You’ve come to the right place! Keep reading to learn how to determine if a balance transfer or debt consolidation make sense for you.
Balance Transfers vs Debt Consolidation
Before we dive in to whether they are right for you, we need to define what we’re talking about.
A balance transfer is a way to transfer an existing debt to a credit card. Generally, you can either transfer the debt directly from another card or use a balance transfer check. Balance transfer checks can pay off pretty much any other type of debt, like a car or personal loan.
Balance transfers almost always have a one-time fee and a low introductory interest rate for a set period of time. For example, some balance transfers have a 2% fee, and a 0% interest rate for the first 12 months. Then, the interest rate jumps up to your regular credit card rate, usually more than 15%.
Debt consolidation is when you take out a personal loan and use the proceeds to pay off multiple other debts. These can be credit cards, student loans, or other personal loans. Generally, debt consolidation loans don’t have an origination fee and the interest starts immediately. Recently, I have seen debt consolidation offers with interest rates around 5% to 7% .
Okay, now that we know what a balance transfer is and what debt consolidation means we can figure out how to determine if these financial tools are a good idea.
Both a balance transfer and a debt consolidation loan move your debt from one lender to another. And, the only reason to move debt from one lender to another is if you can get a lower interest rate.
To determine your savings, subtract the new interest rate from the old rate, and multiply by the balance. That is approximately how much interest you will save in the first year.
Pro-Tip: you will actually save a bit less than that amount. This is because you will be reducing your principal during the year, but this is a close-enough approximation.
For example, let’s say you have $20,000 on credit cards at 15%. And, you can consolidate to a personal loan at 7%. That means your interest rate will drop by 8%. In the first year, you will save $1,600 in interest (8% of $20,000).
Compare All Fees
Before you can decide if a balance transfer or debt consolidation is a good idea, you also have to add up all of the costs.
Balance transfers almost always have a fee. Consolidation loans may also have an origination fee.
In our example, lets say that the origination fee is 2%. That means when you transfer your $20,000, it will cost you $400.
Then you divide the fees by the annual interest savings, which will give you how long (in years) it will take to get your money back. In this example it will take you 3 months, or one quarter of a year to get your money back ($400/$1,600 = 0.25).
So, as long as you are going to have this debt for significantly longer than 3 months, in this example, consolidation makes sense.
This is the exact same math to determine if it’s time to refinance your mortgage. This shouldn’t be a surprise because balance transfers and debt consolidations are the exact same thing. You are moving your debt from one lender to another.
There is an added danger for balance transfers. Generally, the introductory rate expires after a period of time. This can be a year or two. Then, after the intro period ends, the rate skyrockets.
I do not like to paint myself into future corners. I try to avoid putting ticking time-bombs in my finances. Balloon payments and short-term introductory offers require special attention before deciding if they are a good idea.
If the interest rate on your current debt is already super high, then a balance transfer may not be a bad idea. For example, if your balance is $20,000, the interest rate is 15%, the balance transfer rate is 0% for 12 month, the fee is 2%, and the rate after the intro period is also 15%, then this is a good deal. You will pay $400 in fees and then no interest for a year. Then, next year your interest rate jumps back up to what it was before.
However, if you have debt with an interest rate that is less than what the rate will jump to after the intro period is over, then you should try to avoid a balance transfer. If your debt is at 5% now and the rate after the intro period is 15%, then you have just put a time-bomb in your finances. It is probably not worth the risk.
The only way I would consider something like this is if I knew I would have the debt paid in full well before the intro period is over.
Debt consolidation can be a great tool if it lowers your interest rate and allows you to pay off the debt earlier. But, just like balance transfers, there is a hidden danger.
If you use debt consolidation to pay off credit cards, then you have a huge danger: available credit. When you use debt consolidation, you lower the balances on your credit cards by taking out a personal loan.
That means, your credit cards are just sitting there with no balance and available credit! If you are not careful, within just a few months of a debt consolidation, you run the risk of doubling your debt!
DANGER DANGER DANGER
To avoid this risk, I highly recommend cutting up those cards and closing the accounts as soon as their balances are transferred to the consolidation loan.
Consolidating loans does not reduce their balances. Having all that new available credit on your cards could make your loan consolidation one of the most expensive mistakes you’ve ever made!
Debt Forgiveness or Settlement
Before I leave this topic, I have to mention a financial product that has hurt way more people than it has helped.
Debt forgiveness, also known as debt settlement, is a service where someone promises to settle your debt for ‘pennies on the dollar’. You’ve probably seen the ads on TV where they say something like “If you have more than $10,000 in credit card or IRS debt, call now and let our experts help you settle for less.”
Never call that number. Ever.
Here is how debt settlement works. First, you stop paying all of your debts. You cannot negotiate a lower payoff on a debt that is current, so you have to go into default. This crashes your credit score.
Second, you start paying a monthly payment to the debt settlement company. They take a fee out of your payment and put the rest aside with your name on it. Then, they wait.
After a few months, they start contacting your creditors and asking them to settle your debts for less than you owe. If they are successful, they give your creditor some of your money, the creditor tells the credit bureau that the account was charged off (further damaging your credit). And, then they issue a 1099 in your name to the IRS! All of the debt they forgive is counted as taxable income. So, when tax day comes, you are going to owe Uncle Sam.
Debt settlement ruins your finances. And, it is morally murky (at best). If you are current on your debts and you intentionally stop paying so that you can negotiate a lower pay-off, that’s the same as stealing in my opinion. You borrowed the money and you spent the money. You promised to pay it back. So, find a way to pay it back.
Every day, we are bombarded with advertisements. There are so many ads for financial products that will solve all of our problems.
Unfortunately, there are no financial products that will pay off your debts for you. You borrowed the money, so you need to figure out a way to pay it off.
However, there are certain times when it makes sense to move your debt from one lender to another so that you can get better terms.
If you can lower your interest rate enough so that you can save more than the fees in a relatively short time, then a balance transfer or debt consolidation may be right for you.
But, be careful. Avoid the trap of available credit. Make sure than the result of this move is that you get out of debt faster, not slower.
I hope this has been helpful! I welcome your comments with your thoughts and questions. And, don’t forget to subscribe to the newsletter to get notified whenever a new article is posted.