A balance transfer occurs when you go from owing an outstanding balance on account A to owing it on account B. Although it is called a "balance transfer," what is actually happening is paying off the balance of one card with another card, but for the sake of simplicity, we will continue to call it a "transfer."
This transfer is usually done with the intention of saving interest on the outstanding balance since the new card (the one used to pay off the outstanding balance) typically offers an introductory APR of 0% for up to 18 months.
Although it sounds tempting and millions of people perform balance transfers all the time, it is not always the best idea. It can be a good temporary solution to get out of or reduce debts that have been difficult for us to pay, but it is not a magic solution.
How a balance transfer works
Let's say you have $5,000 in debt on a credit card with 25% interest and you can pay $450 a month. If you do nothing, it would take you 13 months to pay it off entirely and you would pay about $630 in interest.
However, if you do a balance transfer to a card with 0% interest for 12 months, you will pay a cost of around 3% for the balance transfer, which would be $150 and is added to your total debt, so now you have a new debt of $5,150 but at 0% interest.
If you stick to the plan of paying $450 a month toward that debt and do not spend any more on that card, you will pay it off in 12 months, you won't pay even $1 in interest, and along the way you will have saved about $480 that you stopped paying in interest ($630 - $150). This definitely works in your favor.
The problem with balance transfers
This is what usually ends up happening: The person gets overconfident with the introductory 0% period, keeps using the card, the 12 months at 0% end, and they still have debt, either because they didn't pay the original debt or because they started spending again with that card, and the $450 a month payment plan no longer makes sense.
By then, they might decide to get another card and do another balance transfer, but as we have already seen, these do not come without an additional cost, so either way we are always going to pay extra unless we decide not to fall into more debt, which will always be the best financial decision.
When should I do a balance transfer?
There is no doubt that 0% interest is an advantage, it is literally free money, but we cannot ignore the introductory period and it is imperative that the balance is at $0 by the time the 0% APR ends.
If you are a responsible person, you probably won't need to do a balance transfer in the first place, but we understand that emergencies happen and sometimes our emergency fund is not enough, so the card was the only alternative.
In those cases, we would without a doubt resort to a balance transfer to escape paying extremely high interest. Just make it a priority to finish paying off the entire balance before the introductory 0% ends. Divide the new total balance by the months of the offer; if the debt is $5,150 and the introductory period is 12 months, you know that you absolutely have to pay $429.17 to that card for the next 12 months.
We have done a couple of balance transfers in the past, and we can say firsthand that it is an excellent option to save on interest along the way, as long as you have a payment strategy to clear the debt before the promotional period ends.
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Why do banks offer this?
There is no doubt that 0% interest is an advantage—it is literally free money—but most of the time we neglect the grace period and end up paying some interest. Banks know this.
Banks offer balance transfers with 0% interest to attract new customers and generate long-term profits. But they also get a small short-term benefit with the transfer fee they charge, which is between 3% and 5% of the outstanding balance to be transferred.
Ultimately, the bank is attracting a customer who likely comes from the competition while generating immediate income at the moment of acquiring the customer, and has the potential to make a profit in the long run, either through the interest they charge on the outstanding balance once the promotional period ends, or because the person genuinely started using the card and took on a new balance.
Although the most lucrative part for the bank comes from people who did the transfer and, at the end of the 0% period, still left a balance and ended up paying interest. It is an excellent proposition for any bank.
Do balance transfers hurt your credit?
Balance transfers can affect your score at first, as a hard credit inquiry (Hard Inquiry) will usually have to be made.
In the long run, it could improve the score if credit utilization is lowered, which is usually the case. This will only work if the balances on other cards are not increased.
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