Monday, January 7

Transfer Fees and Minimum Payments

You just received a fantastic balance transfer offer in the mail and you have a couple of credit card balances that you have been thinking about consolidating. Maybe this is the time! Should you transfer those balances using this offer? Let's take a look to find out how much it might cost.

So the offer says that you can transfer your balances at a low 3.9% fixed rate for 12 months. Sounds reasonable, after all, you are paying 16% on the accounts that you want to consolidate, so at least for the first year (if you carry a balance this long) you will have paid less in interest. So far so good.

The transfer fee (see the small print on the offer that you received) will increase the balance that you are transferring, and you will pay interest on this transfer fee. In our example, let's use a nice round number, say $6000, as the amount that we are thinking about transferring.

What would it cost if you did nothing and decided not to consolidate and transfer the balances? According to Bankrate's credit card payment calculator, it would take TWENTY FOUR YEARS and cost of over $6,500 in interest to repay this debt if you paid just the minimum monthly payment. If you were to instead make a dedicated payment of $200 per month (instead of whatever the minimum payment is) you would retire the obligation in just 39 months, and pay only $1,714 in interest. Now, if the minimum payment was 2.5% of the outstanding balance, then it would be $50 more each month to save almost $5000 in interest and shave a couple of decades off of the time it would take to pay it back!

Do we agree that if at all possible, you should pay a regular fixed amount each month rather than making just the minimum payment?

Alright, now back to the balance transfer. Assuming that the balance transfer fee is 3% of the balance transferred, the 'new' balance on the card that you are transferring to would be $6,180.00. How does this compare to just leaving it on the other card and making fixed monthly payments? Let's take a look.

Because the interest rate on the transferred to account is fixed for only 12 months, we need to take an additional step to calculate the total costs. During the first 12 months, you will have paid $220.00 in interest, paying the principal down to $4,751. If instead you made a fixed monthly payment of $200 per month, your interest expense would be $207, and your outstanding balance would be $3,987. Now we have to make some assumptions as to what your adjusted interest might once this introductory rate of 3.9% expires at the end of 12 months.

Most all credit cards use the Prime Rate as an index. To this they add a margin for risk. Let's base our scenario on today's current Prime Rate of 7.25% with a margin of 8.75 added for risk, making your adjusted rate 16.00% (note that this new rate is the same as what the old credit card rate is at today..). Note that these rates are subject to change anytime that the Prime Rate changes. For our purposes, we will assume that the Prime Rate stays until the balance has been paid in full.

If you had paid only the minimum monthly payment for the first 12 months, and assuming the adjusted rate thereafter is 16%, it will take you 20 years to payoff the remaining balance, and the interest expense would be $3,949. If you dedicated $200 per month for this debt, it would be paid in 28 months at a cost of $845.00.

Now, let's see how the transfer option works out...

Option 1- Do Nothing
It will take 288 Months to repay, and cost you $6500

Option 2- No Transfer, Dedicated $200 Monthly Payment
This option reduces the time to pay to just 39 months, and costs $1714

Option 3- Transfer, pay minimum
This option shaves 7 months from the term, and saves quite a bit, costs $5548

Option 4- Transfer, Dedicated $200 Montly Payment
Here you have the best of both. Retires debt in 29 payments and costs $1400

As you can see, doing something is a whole lot better than doing nothing! If you were to transfer the balance and make only the minimum payment, you would payoff the debt 7 months sooner, moreover you would save almost $1000 in finance charges. No, over 20 years, that is not a whole lot of money but it is money that you did not give to the credit card company.

Quite obviously, based upon our assumptions that the adjusted interest rate will not change (unless you have a fixed rate card, it will!), the apparent best choice would be to take the balance transfer option and dedicate a higher monthly payment. Doing so will cost you significantly less AND get payoff the obligation much faster.