How a credit card can help you get out of debt, not deeper into it
Balance transfer cards can be an effective way to get out of high-interest debt traps
Dubai: When it comes to credit cards, it’s highly likely that you would have been warned more of its dangers, such as high interest charges, exorbitant fees, overspending by the cardholders, and the high risk of falling deeper in debt.
But what if there was a way to use a credit card to get out of debt, rather than deeper into it? As credit cards are known to only leave you with more open credit, which means all the more lure to spend and rack up even more debt, that’s not always the case.
“While it can be sensible to have a credit card that gives you the chance to rack up savings by earning a lot of rewards or cashbacks, it’s futile if you’re carrying a balance and paying high interest,” said Abu Dhabi-based consumer credit analyst Rajesh Markara.
“One nifty way to get out of debt is to complete a balance transfer. You can transfer debt from a high interest credit card to a balance transfer credit card that offers no interest for up to two years.”
Even though you must think that another credit card is the last thing you need, especially if you have high-interest credit card debt, type of credit card debt could help your situation — if you use it the right way. This type of card is a balance transfer card.
How balance transfers work
Each balance transfer credit card has its own unique introductory offer you can use to your advantage. It all boils down to a limited period of zero per cent Annual Percentage Rate (APR), which refers to the yearly interest rate you'll pay if you carry a balance on your credit card.
Most balance transfer cards offer zero per cent APR from 12 to 21 months, meaning you won't pay interest on transferred balances during that time. However, some balance transfer cards charge a balance transfer fee that typically works out to 3 per cent or 5 per cent of the balance you transfer.
Here’s an example. Let’s say you have Dh10,000 in credit card debt at 19 per cent APR and you're currently making a payment of 5 per cent of your balance, or Dh500 per month. At this rate, it would take 25 months to pay off your debt, and you would shell out Dh2,120 in interest over that time.
Now, you apply for a balance transfer card that gives you zero per cent for 21 months in exchange for a 5 per cent balance transfer fee. Once you transferred your entire balance and added in the fee, you would start repayment owing Dh10,500 (Dh10,000 plus a Dh500 balance transfer fee).
However, the fact that you're not paying interest means you could continue paying Dh500 per month and pay off your entire balance with zero interest in 21 months. In other words, your balance transfer card could trim four months off your repayment timeline and save you Dh2,120 in interest.
“However, the above impact is nominal compared to how paying down debt ultimately improve your credit score. So if you transfer your balance and immediately start paying down debt, you could also make a positive impact to your credit score.“
How to choose a balance transfer card
Whether you want to pay down a large purchase without interest or save money by consolidating high interest debt at zero per cent APR, it's crucial to make sure you wind up with a new credit card that offers the perks you want.
According to Markara, here's what you need to look for as you decide, particularly when you are transferring your balances with the end goal of eventually getting out of debt..
1. Card that gives you the time you need
If you want to consolidate debt at zero per cent APR, you'll need to make sure you have enough time to pay off your debt entirely. See which card give you plenty of time to accomplish your goal. If you don't, you'll wind up paying off debt at the standard variable APR, which will likely be very high.
2. Don't pick a card that entices you to overspend
If you're really trying to pay off debt, stay away from cards that offer big sign-up bonuses within the first few months. You should use your balance transfer credit card to save money on interest, but don't use it for everyday spending.
3. Make sure to take card fees into account
Most zero per cent APR credit cards don't charge an annual fee, but you should still compare balance transfer fees and other potential fees you may be charged such as late fees and over-limit fees.
‘Deferred Financing’ or ‘Waived Interest’?
“At first glance, it might seem you can’t go wrong with a card with a promotional 0 per cent balance transfer APR. However, knowing the difference between deferred financing and waived interest could end up being worth hundreds of dirhams,” added Raul.
“Deferred interest is most likely the offer you come across directly from a store. For instance, you can currently take advantage of 0 per cent deferred interest financing on certain purchases for 6 months on purchases costing under Dh500.”
The interest accrues during the promo period, but you don’t pay the interest unless you haven’t paid off the balance by the end of the promotional period. Further, if any of your payments are late, you could also be billed all of the interest that accrued since you made the purchase.
“Waived interest, on the other hand, is commonly offered by standard credit cards. If your credit card offers 0 per cent interest that is waived, you are typically able to take advantage of the promotional period without accruing interest,” Raul further explained.
If for some reason, you don’t pay your balance in full when the promotional period ends, you just start to pay interest on your balance according to the card’s APR at the moment. Check your credit card conditions and take note of terms such as “financing” and “deferred interest” if you aren’t sure.
In either event, it’s best to pay your balance off completely within the promotional period, but if there’s any chance at all that you won’t be able to pay your balance down during the designated period, it’s best to make sure your interest is waived rather than deferred.
Bottomline?
Once you transfer credit card balances to a balance transfer card with the goal of paying off debt, it might be tempting to use your old credit card again, but you should avoid using it altogether.
“If you start using your old credit card for purchases and fail to pay off your balance each month, you could easily rack up even more debt that will accrue interest and make your debt payoff journey that much harder,” added Markara.
“Also, most often, those in deep debt transfer a balance but never build up the discipline to pay down their debt. Then, when their zero per cent introductory offer is over, they're still left with a sizable balance they failed to pay off.”
The easiest answer for those who constantly struggle with debt can be to just transfer the balance to new and different zero per cent APR cards over and over. “If you keep using balance transfers, you’re no longer using the strategy to pay down debt, but stay in debt,” cautioned Markara.
“Even worse, you'll likely be paying a balance transfer fee of 3 per cent to 5 per cent of your balance each time you transfer. While those fees might seem worth it, they will add up over time.”