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Balance transfers - explained
A balance transfer can be an incredibly effective way to lower your credit card payments, clear your debt months sooner, and save a whole lot on interest in the process. Admittedly though, balance transfers aren’t the most straightforward. If you aren’t familiar with the terms, conditions, and details of how they work, you might not take full advantage of the benefits a balance transfer has to offer.
Credit card interest 101
Before we jump into the details of how balance transfers work, let’s cover some of the basics around credit card interest.
Types of credit card interest
Most credit cards have three interest rates, each for a different type of card activity.
- Purchase interest rate: the most common interest rate that’ll kick in if you carry a balance when making everyday purchases;
- Balance transfer rate: what you’ll owe on any balance you move from one credit card to another; and
- Cash advance rate: what you’ll be charged on any money you withdraw from your credit card at an ATM.
Depending on the credit card, all three types of interest may have the same rate or they may all be different. For instance, the BMO Preferred Rate Mastercard charges a flat 12.99% annual interest rate across the board while the MBNA True Line Gold has a low 8.99% interest rate on purchases and balance transfers but a 24.99% on cash advances.
How credit card interest is calculated
The formula behind credit card interest can be quite complicated and we cover it in detail here. But below, we provide a simple cliff notes explanation to get you up to speed on the fundamentals.
As standard, all credit cards show interest rates on an annual basis (for instance, 19.99% annually). However, interest is actually calculated on a daily basis and charged every month.
The first step of the calculation would be to turn your card’s annual interest rate into a daily rate. That’s as simple as taking the annual rate (19.99%) and dividing that percent by the number of days in the year (365). With this formula, you’ll find that you owe about 0.0547% (19.99% ÷ 365) in interest every day you owe money on your credit card. Therefore, if you owe a $5,000 balance, your interest over one day would be $2.738 ($5,000 x 0.0547%). This interest payment is calculated each day, and based on your average balance over the course of one monthly billing period, you’ll be charged interest as an additional cost on your next credit card statement.
What is a balance transfer?
A balance transfer involves moving your balance from one credit card (with a high interest rate) over to another credit card (with a lower interest rate) to pay off your debt sooner. Along with the ability to access lower rates, balance transfers also help you more easily stay on top of payments. Rather than carrying debt on multiple credit cards with different balances and due dates, you can consolidate your debts into a single balance transfer credit card and manage just one credit card statement.
Balance transfer credit cards and promotions
The best balance transfer credit cards come with rock-bottom promotional balance transfer rates.
For instance, let's say Card X has a promotional balance transfer rate of 0% for ten months. So, if you transfer a balance you owe on your current credit card over to Card X, you’d owe no interest for a limited time and can pay down your principal debt (the amount you actually owe) a whole lot faster.
Here’s a comparison of how much you’d save in interest if you transferred your debt over to a credit card with a 0%, 10-month balance transfer offer versus if you kept your balance on a conventional rewards credit card. In this example, we assume you owe a $2,500 balance and pay $300 towards your card debt every month.
Balance transfer card
Typical rewards card
0% for 10 months
Monthly until your balance is paid off
Total interest owed
How new purchases are dealt with on a balance transfer credit card
Balance transfer credit cards can be a great way to address past credit card debts you’ve racked up - but won’t help you save on new purchases.
Here’s an example to help explain why.
Let’s say you opened the Tangerine Money-Back Mastercard, which currently comes with the following interest rates:
- Balance transfer rate: 1.95% for 6 months
- Purchase interest rate: 19.95%
Any balance you transferred over to the Tangerine Money-Back Mastercard from another credit card will accrue interest at an annual rate of 1.95% (the balance transfer rate). However, if you buy something new with the Tangerine Money-Back Mastercard, that purchase will accrue interest at 19.95% (the purchase interest rate) - not 1.95%.
Fundamentally, it’s important to know balance transfers and new purchases are regarded as different types of credit card transactions that each have their own interest rates. Any payments you make towards your credit card will also go towards paying down your transferred balance first, which means any new purchases charged to the credit card will accrue interest at a higher rate for a longer period of time.
The biggest takeaway here is you should strategically avoid charging any new purchases on a balance transfer card until the debt you transferred over is paid off. Remember, the goal of a balance transfer credit card is to help clear off past debts. If you do need to make new purchases, try and avoid using your balance transfer credit card and instead charge another credit card or use debit or cash instead.
After the balance transfer promotion period ends
Balance transfer promotions are, by their very nature, only available for a limited period of time.
Once the promotional period ends, the card’s regular interest rate on balance transfers will kick in. For instance, if you transferred over a $10,000 balance but only managed to pay off $5,000 during the promotional period, the remaining half you owe will accrue interest according to the card’s standard balance transfer rate. Hence why it’s good to have a plan in place and try to pay off all or as much of your transferred balance as possible within the set promotional period.
If you’re transferring a particularly large balance or you suspect you won’t be able to pay off the transferred balance in its entirety within the promotional period, you’ll want to try and scope out a credit card that has both a low balance transfer offer as well as a low standard rate.
For example, the BMO Preferred Rate Mastercard has a 3.99% balance transfer offer for the first nine months, but its regular interest rate after the promotional period is just 12.99% - which is still considerably lower than the average 19.99% found on most credit cards. On the other hand, the BMO CashBack Mastercard has a lower 1.99% balance transfer offer for nine months, but afterward, the interest rate on any remaining amount you transferred over will spike up considerably to 22.99%.
Weigh the pros and cons and identify which credit card is best for you based on how likely you can clear off your transferred balance in full. And make sure to always read the fine print to understand what your interest rate will be once the balance transfer offer ends.
Make sure you make at least the minimum payment
If you don’t make at least the minimum payment every month (or skip payments altogether), you could be disqualified from the credit card’s promotional balance transfer offer and your interest rate could increase sharply. Make sure you have the cash on hand to meet your monthly payment obligations before you jump ahead and open a new balance transfer card.
Balance transfer fees
In most cases, taking advantage of a balance transfer means you’ll also have to pay a flat transfer fee.
This convenience fee is usually calculated as a percentage of the total balance you’re moving over (for instance, on a $2,500 balance, a 1% transfer fee would add up to $25) and will be charged at the time of the transfer. Each credit card and card issuer may charge a different percentage.
While fees may be inconvenient, it can be well worth it to access the ultra-low interest rates offered by balance transfer credit cards since they can help you save several hundred (if not thousands) of dollars in the long run.
How balance transfers affect your credit score
By taking advantage of a balance transfer promotion, you’ll gain access to rock-bottom interest rates that’ll help you pay off your credit card balance faster and reduce the amount of debt you owe sooner. And that can lead to a major lift in your credit score.
Your overall debt load is a key component of your credit report and accounts for roughly 30% of your three-digit score. Most credit reporting agencies and lenders prefer you carry no more than 30% of your overall credit limit as debt. Anything more than that, and it could be seen as a sign you’re over-leveraged and over-reliant on credit.
By paying off your balance faster and reducing your debt load with a balance transfer card, you can see a marked improvement in your credit score.
The one thing to consider is that in order to gain access to the best balance transfer offers, you’ll need to apply for a new credit card and undergo a hard credit check. While that can ding your credit score, credit inquiries only have a small and temporary impact. And in the grand scheme, your credit score and your wallet will benefit from carrying a lower debt load.
Balance transfers won’t earn rewards
A balance transfer isn’t considered an everyday purchase. So, even if the balance transfer credit card in question usually earns points or cash back on new purchases, you won’t earn any on balance transfers. That may seem like a downside, but it’s important to remember a balance transfer is about paying off debt rather than maximizing rewards. Plus, when considering balance transfer offers can reduce your interest rate by anywhere from 17% to 19%, the benefit to your bottom line is huge even when considering points or cash back aren’t part of the equation.
Balance transfers have to be between different banks
Unfortunately, you can’t take advantage of a balance transfer offer if you’re moving balances between two credit cards from the same bank or credit union. The balances you’re moving over must be transferred between cards from different issuers.
Natasha Macmillan, Business Director of Everyday Banking
With over a decade of experience in the finance industry, Natasha works closely with Canada's top financial institutions - from banks to credit unions - to help Ratehub.ca's 1,200,000 monthly users get matched with the right banking products. read more
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