I have had a lot of people ask me whether it is better to take a low rate balance transfer offer from a credit card company or apply for a regular low rate card that usually carries an annual fee of $25 to $35 annually.
Most assume that the regular low rate card will offer a substantially lower total cost, even with the annual fee, because low rate balance transfer offers assume that after a short introductory period of three to six months the rate increases to 18 or 19 per cent or more.
Applying financial theory to this problem shows that neither offer provides any substantial savings.
An example will demonstrate.
Assume that you have a $2,000 balance on a credit card at a rate of 18.90 per cent. Another bank has offered you a low rate balance transfer of 1.99 per cent for the first six months after which the rate will rise to 18.90 per cent.
You could also be approved for a regular low rate card with a rate of 10.90 per cent and a low annual fee of $25. Which do you take?
As I said earlier, most intuitively take the regular low rate card with the 10.90 per cent rate, reasoning that even with the annual fee the total cost is substantially lower.
Using a concept from finance theory called Internal Rate of Return (IRR) shows that neither offer is significantly better.
IRR is essentially the interest rate at which you break even on an investment or loan. For our purposes let’s refer to the IRR as the average interest rate on a credit balance.
The low rate balance transfer offer, assuming that you want to pay off the balance in 36 months, results in a payment of $57.28 for the first six months at a rate of 1.99 per cent, followed by a payment of $70.49 for the remaining 30 months at a rate of 18.90 per cent. Total interest cost $458.22 or an average interest rate of 13.53 per cent.
If you accept the regular low rate card (10.90 per cent) your payment would be $65.38 a month for 36 months. Total interest cost $353.77.
Including the $25 annual fee, your total cost over 36 months would be $428.78, an average interest rate of 13.21 per cent.
So neither option really provides you with much relief. Both are essentially two sides of the same coin.
What options do you have?
After making sure that you have enough savings to cover six months of rent, mortgage and debt payments, pay down credit card balances with any remaining cash.
Earning a .50 per cent interest rate on savings just will not compensate you for the expense of maintaining a credit card balance.
Second, talk your bank or credit union about a consolidation loan for remaining debts.
Consolidation loans are usually paid off over 2-3 years so expect the loans officer to demand a higher monthly payment but the good news is that the loan rate may be substantially lower, especially if you offer good collateral, such as the equity in your home or investments.
Finally, whatever choice you make do not use your credit card for any more purchases. Cut the card in half and continue to make the payments.
If you really need to keep the card, then I suggest freezing it. Yes, that’s right put the card in a zip lock bag and put it in the freezer. You’ve just created your own cooling off period!
The next time you really want that new gadget in the store window you will have to go home and let your card warm up.
Finally, remember you are in control of your financial destiny.
Patrick O’Meara is a business instructor and program co-ordinator for the diploma in financial services at Red Deer College.