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Dirty Little Balance Transfer Secrets

by Mike

Tim Chen is founder and CEO of NerdWallet.com, a website that helps consumers to compare credit card offers.  Tim also educates consumers about credit cards and debt management at the Forbes MoneybuilderBlog, the Huffington Post, and the Christian Science Monitor.

Remember the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act) that was supposed to keep the average American from being taken hostage by credit card companies? The good news is that much of it has done just that.But before consumers claim victory, there are some dirty little secrets you should know.

The average American household has unpaid credit card debt of nearly $5,000and most are looking for the cheapest way to manage that debt until they can pay it off. If you’re like many, you’ve probably considered transferring your balance to a low rate card – but is it really a good idea?

Balance Transfer Shenanigans Before The CARD Act

Let’s set up a hypothetical situation. You are one of those households with $5,000 in credit card debt and last year you receiveda credit card offer from First Friendly Bank that has“0% interest balance transfer” written in big blue letters on the front of the envelope.  You, being the responsible consumer you are, read the fine print and noticed that the regular interest rate is 15%.

You went ahead and made the transfer and felt good about your choice, because you were certain you’d have that $5,000 paid off long before that 15% ever set in. Then, since you still had some room on the card,you used it to pay $1,000 worth of bills that had been piling up.

In a hurry to get rid of your debt, you sent$500 as your first payment and the bank applied it to your “balance,” but what wasn’t clear on your statement is that your balance transfer and your other bills are considered different balances and incur different interest rates.So howwould the bank split your $500 between each balance?

Well if you think of each of these two balances as separate buckets, the bank would apply your $500 to the balance transfer bucket. In this pre-CARD Act world, the other bucket wouldn’t see any payments until the balance transfer bucket is empty.  This means that you would be charged 15% on that $1,000 every daythat your $5,000 wasn’t paid off. If it took you a year to pay your $5,000, your $1,000 bucket would see more than $160 of interest added to it during that year, and that would continue to compound into significantly higher numbers if it took you more than a year.

So Balance Transfers Are Safer After the CARD Act, Right?

The credit card legislation signed in to law by President Obama in 2009 forced banks to change the behavior described above.  Credit card companies now must apply your payment to the bucket with the highest interest rate first, regardless of how many buckets you have and how big the balances are in each bucket. But nothing’s ever 100% safe – there’s still a catch found in the fine print: Only payments above the minimum payment amount have to be applied to the highest interest rate bucket.  They still have the freedom to apply minimum payments to any balances they wish.

So if you’re one of those who can only afford the minimum payment on your credit cards, all of it is going to the balance transfer bucket, so you’ll continue to pay off your 0% or low interest rate cardbalances, while your purchases accrue at much higher rates. This is just another reason why you should do whatever you can to pay more than the minimum each month.

Other tactics to watch out for

In addition to the interest rates that banks charge and the payment methods they employ for balance transfers, banks also generally charge upfront fees on the transferred balance.  A year ago, these fees only went as high as 3%, so you would be charged $150 out of the gates on that $5,000 transfer.  Nowadays, balance transfer fees are as high as 5%, or $250 on your hypothetical transfer.

The other balance transfer gotcha that banks have been employing in the post-CARD Act era is luring people into “professional” credit card deals.  Professional is just an ambiguous synonym for business credit cards, which are not covered by the protections in the new law.  So if you use one of these professional credit cards to transfer balances or to take advantage of introductory purchase APR deals, the issuer still has the freedom to apply your payments to low-rate balances and charge you maximum interest.

As a takeaway, credit cards can be a valuable tool for money management if used responsibly and with an eye on the fine print.But they only truly work in your favor if you know how to mitigate the fees facing you at every turn, and if you can pay the card in full each month. Interest charges and unnecessary fees will lead you down a black hole and should be avoided at all costs.

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