May 30, 2018
Balance Transfer Cards vs Debt Consolidation Personal Loans
If you have debt, you’re not alone. The majority of Americans have debt, and paying it down is not easy. In fact, in a CBS News report on Moneywatch¸73% of Americans were reported to be in debt with an average total balance of $12,875. Around 68% of these individuals had credit card debt, followed by auto loans (25%), personal loans (12%) and student loans (6%). But there are two hacks that consumers can use to pay down debt FASTER – a balance transfer credit card and a personal loan specifically for debt consolidation.
In this guide, we’ll analyze these two hacks to help you pay down debt quickly. This guide is divided into the following sections:
- Balance Transfer Card – what is it?
- Debt Consolidation – what is it?
- The Important Stuff to Know
- What kinds of debt can I transfer?
- Origination fees
- Temptation of a balance transfer card
- Credit scores
- Which is best for me?
Balance Transfer Card – what is it?
A balance transfer card is a super simple concept – it allows you to transfer the principal (or balance) of debt that you have to a balance transfer card. Why would you want to do this? Because most balance transfer cards have an introductory period where you pay 0% interest. This introductory period is typically between 6 to 24 months, and you can use that entire time to use the money you would have been paying for interest and, instead, pay it towards principal. After that introductory period, you’re going to be paying whatever the interest rate is on the card. Like any credit card, this interest rate is usually pretty high, so it’s critical that you pay down as much as possible during the introductory period. And like any credit card, the amount that you pay will vary depending on your balance at the time.
Let’s run through a quick example. I have $10,000 in credit card debt at a 26% interest rate. That means every month, I need to pay about $244 in interest. If I pay $244 every month for the next 12 months, how much balance will remain on this credit card debt? Still $10,000. Because that $244 is just interest, so I’m not actually contributing anything to the balance – this is why credit card debt is so difficult to pay off. However, if I transfer my $10,000 in credit card debt to a balance transfer card with 0% introductory period for twelve months, that means I have ZERO interest payments for 12 months. I keep paying the $244, but it’s applied to my balance. $244 x 12 months = $2,928. Instead of owing $10,000 after one year, now I owe $7,072 (which is still too much, but you get the idea).
Debt Consolidation – what is it?
Debt consolidation is when you take existing debt and move it over into one loan at a lower interest rate. Wait a second, how’s that different than a balance transfer? A balance transfer is all about the 0% introductory period. Debt consolidation is all about the lower interest rate. When you consolidate debt, you’re making your life a bit simpler by just having one monthly payment to make, but more importantly, you’re paying a lower amount in interest each month on all that debt than you would have if it was separate.
Let’s run through a debt consolidation example. Again, I have $10,000 in credit card debt at a 26% interest rate. That means every month, I need to pay about $244 in interest. Instead of a balance transfer card, I decide to consolidate my debt with a lender. I transfer the entire $10,000 balance over to a new lender, and my new interest rate is 14%. The interest that I need to pay each month is $124, so if I continue to pay $244, the extra is applying towards my balance. After 12 months, I’m still going to owe $8,502. But my interest rate will remain at 14%. In this example, paying $244 per month will take me 4.8 years to pay off the debt. That’s a long time, but if I had kept the debt on my original credit card with the higher interest rate, I would have still owed $10,000 after 4.8 years of paying the interest-only.
The Important Stuff to Know
In our examples, if you were paying really close attention, you may have noticed that a balance transfer credit card is going to be insanely awesome for the introductory period but expensive after. Whereas the debt consolidation is a good deal – but not insanely awesome – from day one and then never gets worse. That means:
- Balance transfer cards – best for people who can pay down a LOT of the balance during the introductory period.
- Debt consolidation loans – best for people who can’t afford to pay much more per month than they are paying today.
That’s the bottom-line. But let’s get into the details even more. Here is the other important stuff you need to know:
What kinds of debt can I transfer?
The types of debt that you can transfer to either a balance transfer card or debt consolidation loan are pretty similar. In general, it’s any unsecured debt which means debt that is not secured by an asset. This means you can transfer:
OK to Transfer
- Credit cards
- Credit cards in someone else’s name
- Retail store cards
- Personal loans
- Student loans
- Medical bills
- Utility bills
- Cell phone bills
- Income taxes owed (if they have not gone into collection)
Can NOT Transfer
- Home Loans
- Home Equity Lines of Credit
- Boat Loan
- Recreational Vehicle Loan
- Government Loans
- IRS Debt and Back Taxes
Can Maybe Transfer
- Auto Loans (new and used)
Auto loans are a little different because they are typically secured by an asset – your car. However, some have not prepayment penalties and allow for a transfer. When you talk to you issuing bank for your balance transfer card or the lender for your debt consolidation loan, they’ll be able to tell you. But before you open up either, make sure you call the holder of your auto loan to confirm it’s ok.
Finally, you can almost never transfer debt from the same bank that owns your balance transfer card. Meaning, you have debt on a Chase credit card, don’t open a Chase balance transfer card thinking that you can transfer it. You’ll need to pick a balance transfer card from a different bank than Chase.
Also, important note – in most cases, you CAN transfer debt from someone else onto your balance transfer credit card or debt consolidation loan. So if your wife or husband has debt and you want to transfer it to your card or loan (maybe in addition to your own debt), you can do that. But if you are expecting them to help with payments and they do not, know that any credit score impact is on you and you alone.
In assessing whether or not to take out a balance transfer credit card or a debt consolidation loan, probably THE single most important factor to understand is origination fees.
The origination fee is a fee that you pay when you open up the new card or loan. It’s typically 3-5% of the total debt being transferred. Usually, when we hear the term “fee” it’s a bad thing. But in this case, a fee is ok so long as it’s less than what you would have paid in interest. It’s pretty easy to calculate the fee:
- Balance being transferred: Example: $10,000
- Origination Fee %: Example: 3%
- Multiply: Example: $10,000 x 3% = $300
In this example, your balance transfer fee is $300. This is paid one-time only. Sounds like a hefty fee, right? It is probably less than the amount you save transferring your balance. Scroll down to see how to find out if the origination fee is worth it.
Temptations of a Balance Transfer Card
There’s one important aspect of a balance transfer card that you need to understand. It’s a temptation. At the end of the day, it’s a credit card. And it can get you in two ways.
Not paying enough back on the balance
Why do you think that banks are willing to offer 0% interest for the introductory offer? They know that many people won’t come close to getting their balances paid off during that period, and in these cases, they’ll owe a high interest rate on the remaining balance. If you’ve paid it down enough, maybe that’s ok. But if you have a lot of that balance outstanding after the introductory period, you could actually be in a worse-off position.
Using the credit card for new purchases
The second reason banks are willing to give these 0% introductory offers is because a certain percentage of people will use it as a credit card. They’ll make new purchases, and those purchases are NOT interest free. They are the same ol’ high interest rates you get with any credit card you don’t pay back in full. For certain indviduals, having a credit card means they’ll spend money they don’t have. Don’t be these people. If a balance transfer credit card makes sense for you, get it, lock it up, and don’t use it. Then save, save, save and use it all towards paying down your balance.
Impact on Your Credit Score
The last point I want to make sure you are aware of is how both a balance transfer credit card and a debt consolidation loan can impact your credit score. Like any loan you take out, the bank or lender is going to pull your credit and that can temporarily lower your score 5-15 points. Not a huge deal unless you just about to apply for a mortgage, cell phone, or some other product that also requires a credit pull. So just be aware.
If you pay your card or loan on time, both of these products will improve your credit score. That’s true of pretty much any debt. But just opening up the balance transfer card can actually increase your credit score if approved for a higher amount. Let’s walk through how that works.
Say you owe $10,000 in credit card debt on a card that has approved you for up to $15,000. That’s your only credit card. Your credit utilization would be 10/15 – or 66%. The lower this number is, the better. So let’s say you transfer this debt to a new balance transfer card, and the new card approves you for a maximum $22,000. Now, without even paying down the debt yet, your credit utilization is 10/22 – or 45%. That’s significantly lower, and you’d likely see a credit score increase. This would not happen with a personal loan used for debt consolidation, because you would only want to take out the amount you need to pay back – $10,000. This would remain the maximum amount you’re approved foryou’re your credit score is unchanged. It’s not enough of a reason to go with a balance transfer card over a debt consolidation loan, but it’s worth considering in the decision.
Which Is Best for Me?
Finally, the moment you’ve been waiting for – how do I decide which is best for me? As always, I wish I could give you a silver-bullet answer that just applied to everyone. But the answer is always, “it depends,” so let’s break it down as simply as possible.
- Amount of debt that you are transferring
- Current interest rate that you are paying on your balance
- Key Numbers: Balance transfer card
- Origination fee
- Introductory period
- Interest rate after the introductory period
- Key Numbers: Personal loan for debt consolidation
- Origination fee
- Term of loan (how many months)
- Interest rate during term of loan
These are all the numbers that you’ll need. Then, you need to write down the “Best Case” scenario for your monthly payments during the introductory Balance Transfer period. This is the MOST you’ll be able to pay during that period. For instance:
- Best case scenario – I can make payments of $1,100 per month during the introductory period
Then, you need to make the worst case scenario for your payments during the introductory period. For instance:
- Worst case scenario – I can make payments of $200 during the introductory period.
In each scenario, how much would you owe at the end of the introductory period? And then, how many months would it take you to pay off the rest? You go through the exercise again, but do it assuming a personal loan. Which gets your balance paid off quicker? Which ultimately lets you pay less money? Compare it with what you are paying now, and hopefully, the answer becomes clear. Our general rule of thumb is that you need to expect to pay off 40% of the outstanding debt or more during that balance transfer introductory period. If not, you should look at a personal loan. That math is much easier, as it’s just a matter of seeing whether or not the interest rate you qualify for is less than the interest rate you pay now. You can check your actual pre-approved personal loan rateson BrightRates instantly, and there is no impact on your credit score.