How do Balance Transfers Affect My Credit Score?
Balance transfers provide consumers with an easy, convenient, and effective way to reduce their debt obligations. It’s a form of debt settlement that doesn’t require a debt specialist or program, can be undertaken with a few simple moves, and offers a wealth of benefits. But how do balance transfers impact your credit score, do they appear on your credit report, and are there are better ways to pay off your credit card debt?
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What is a Balance Transfer?
A balance transfer is when you move one or more credit card balances to a new card. Often known as balance transfer credit cards, these cards offer an extended introductory period, during which there is a 0% APR rate on transferred balances and purchases. These cards also charge a fee fixed as a percentage of the total balance.
As an example, let’s imagine that you have a credit card balance of $20,000 spread across two credit cards. These cards have an average APR of 25% and you’re paying $500 a month between them. Based on these terms, and assuming you pay exactly $500 every month, the debt will clear in 87 months and cost over $23,000 in interest, which means you will repay a total of $43,000.
Credit card interest compounds on a daily basis, which means you pay interest on top of interest. At the end of the month, the balance has grown because of this compounding interest and when you make the minimum payment, you’re just skimming the surface. It’s like taking two steps forward and one step back, as a sizeable percentage of your monthly payment is pure interest.
If you move these two balances to a balance transfer credit card with an 18-month 0% APR, you’ll initially be hit with a fee fixed at between 3% and 5%, which means your balance could grow to $21,000.
Assuming you continue repaying $500 every month, you will have repaid $9,000 on your debt by the time this introductory period ends, reducing it to $12,000. For this point on, even if the 25% APR returns, the balance will be much smaller, which means your $500 will have more impact, and you can clear the full balance in 34 months at a total cost of $17,000.
This is the general idea, and the above scenario is the least you can commit to repaying your debt. If you really want to clear it quickly and cheaply, you should devote yourself to repaying as much as you can during that period. Increase your minimum, pay extra where possible, and reduce the balance so there is less interest to compound when the introductory period ends.
How Can a Balance Transfer Impact My Credit Report?
A balance transfer can impact your score in both the short-term and the long-term, and this is something you need to know if you’re thinking about applying for a balance transfer card. With that in mind, let’s cover the ways that a balance transfer could impact your score.
Every time you apply for a new loan or line or credit, the lender will initiate a credit check. If it’s a “soft” credit check, it won’t leave a mark, but if it’s a hard credit check it will leave a mark that remains for two years and reduces your score by as many as 5 points.
Soft checks are used by comparison sites and lenders to provide you with a quote. If you accept this quote and take things further, that’s when a hard check may be initiated. This is not something you can avoid—if you follow the application process through to the end, a hard credit check will appear on your report and your score will drop.
Typically, credit bureaus overlook multiple hard credit checks if they occur for the same type of credit within a fixed period, as they want to encourage comparison shopping and understand that this allows borrowers to find the best rates. But this doesn’t apply to credit cards and every hard credit check you incur will reduce your score.
A creditor can’t initiate a hard credit check without your permission, but you can get the information you need about a credit card without one of these checks taking place. Comparison shop, calculate fees, rates, and benefits, and only advance to the next step when you’re confident that you have found the right card.
You can’t stop a hard credit check occurring if you want a new credit card, but providing there is only one of them it won’t have a major impact on your score. What’s more, a hard credit check will only influence your score during the first 12-months, before disappearing entirely after 24 months.
10% of the FICO credit score algorithm is based on new accounts—every time you open a new credit card or apply for a new loan, this aspect of your score will take a hit.
A further 15% of your score is based on total credit age, and this can also be impacted by a new credit card. It’s an average based on all accounts, so when you introduce a brand-new account, that average age will drop.
However, as bad as this sounds, the damage is temporary and after a few months you should see your score improve. Within a year or two, the account won’t be new; it will have aged sufficiently enough to stop impacting your score.
If you ask the average consumer how credit scores are calculated, they may tell you that your score increases when you make repayments on time and decreases when you don’t. Simple, and true. But there’s much more to it than that and one of the most misunderstood aspects of the credit score algorithm is tied into something known as credit utilization.
The more debt you have, the more of a liability you are, but it wouldn’t make sense to base credit scores purely on unpaid balances as it’s all relative—one man’s pocket change is another’s fortune.
Credit utilization is used to account for this and to create an accurate representation of an individual’s debt. Accounting for 30% of your total credit score, a credit utilization ratio compares all available credit (such as a credit limit) against all accumulated debt (such as a credit card balance).
If you have a $10,000 credit limit with a $8,000 balance, your credit utilization ratio is 80%, which is very high. This ratio should be as low as possible, and anything over 40% may have a detrimental effect on your credit score.
The more unused credit you have, the higher your credit utilization score will be, so keep old credit cards active after moving the balances across.
Maxed-Out Credit Card
A maxed-out credit card pushes your credit utilization ratio into dangerous territory, as it means you’re using 100% of available credit on that particular credit card. But that’s not the only issue, as FICO has made it clear that maxing-out your card will also reduce your score, although they haven’t been clear on the specifics.
Balance transfer credit cards are more likely to be maxed-out, as consumers transfer large balances and are then tempted by 0% purchase APR offers. They get trapped in an all-or-nothing cycle, believing they might as well spend a few extra hundred considering they’re already knee-deep in debt. But this is a very risky and reckless strategy and that extra debt could further reduce your credit score.
Other Ways a Balance Transfer Can Impact Credit
The biggest mistake you can make when using a balance transfer credit card is to assume your new provider will somehow be more lenient and will overlook a missed or late payment.
Not only can this strategy result in the termination of the beneficial terms, it will also leave a derogatory mark on your payment history.
Your payment history is the most important aspect of your credit score and accounts for a higher percentage of your score than anything else. Improving this can be a long and slow slog, but decreasing it is as easy as missing a payment. This missed payment could reduce your score by over 100 points and will remain on your credit report for 7 years—all from one seemingly minor mistake.
Your payment history should always be your number 1 priority; don’t miss a payment, otherwise you could be paying for it for years.
How Can I Improve my Credit Score After a Balance Transfer?
Time is a great healer where credit reports and credit scores are concerned. Any damage done by a balance transfer will disappear in time, and in most cases, the damage is minor and won’t impact your chances of acquiring additional credit in the future.
If you’re concerned about your credit score and the damage done by a balance transfer, take a look at our guide to FICO score calculation to better understand how these scores work and what you can do to fix derogatory marks.
Are there Any Better Options?
It’s clear that balance transfers provide many benefits for struggling debtors, benefits that could help them to dig their way out of trouble and get back on their feet in a way that doesn’t require expert help, won’t cost a fortune, and won’t damage their credit report in the same way as bankruptcy or debt settlement.
But these pros are prefaced by several major cons, and before you make a decision on whether this is the right option, you need to consider these issues closely.
For instance, a balance transfer doesn’t fix your budgeting or spending issues, which may have gotten you into debt in the first place. It’s a process that you complete yourself, one that doesn’t require outside help, and without that interjection, there is a serious risk of relapse that could make the situation even worse.
Consider these alternative options to clear your credit card debt, each offering a benefit that you won’t get with balance transfers.
Paying More Than the Minimum = Clear Debt Payoff
Stop rolling your eyes—this is an advice article, what did you expect!?
While many debtors don’t want to hear it, the simple fact is that repaying more than the minimum each month can help you clear your credit card debt quickly, reducing the total interest as well as the term.
You save money because your creditor calculates and compounds interest on a daily basis—the larger your balance is, the more that interest will grow from day to day. When you pay more, your extra money goes towards the principal, the balance reduces, and you save a fortune over the term.
Debt Settlement = Cheaper
If debt payoff strategies provide a careful, considered approach to clearing credit card debt, then debt settlement is the bulldozer that destroys everything in its wake. It’s a fantastic option when your credit score is low, your options are few, and you want to get rid of your debts.
The debt settlement process begins with a debt specialist requesting that you stop making payments on your debts and start moving your money into a secure account. This sends your accounts into default, at which point creditors and collection agencies are more likely to accept a greatly reduced settlement fee.
The debt specialist will then negotiate with your creditors, offering them a cash sum in exchange for an immediate settlement. A few years down the line, all your debts will have cleared, and instead of paying much more than the balance, as is the case with debt consolidation, you’ll pay much less.
Debt Management = More Reliable
One of the best things about debt management is that it’s offered by experienced financial companies who work with you and your creditors to clear your debts quickly and painlessly. They will speak with your creditors to create a consolidated monthly payment, after which, you pay your monthly payments to them and they distribute the funds accordingly.
Debt management programs are aimed at struggling debtors with low credit scores, and they often request that the debtor cancels all but one of their credit cards, which can seriously impact their credit score.
Bankruptcy = All Encompassing
Bankruptcy is not a debt payoff strategy. It’s not an easy, simple or cheap way to pay off your debt, and if you’re concerned about your credit score, it’s one of the worst options there is, as it can reduce your score significantly and make a mark that remains on your credit report for up to 10 years.
So, why’s it here? Well, as destructive as bankruptcy can be, it’s also one of the only ways you can clear all or most of your debt without agreeing to prolonged contracts or paying huge settlement sums.
Chapter 7 is the most common type of bankruptcy in the United States, accounting for 2 out of every 3 personal filings. Chapter 7 is a liquidation bankruptcy, which means all of your assets will be liquidated, and the money used to pay your debtors. The amounts that can’t be repaid will be written off and you’ll be given a clean start.
However, you can’t file for bankruptcy just because you have a little credit card debt and want an easy escape. You need to file a bankruptcy petition, in which you will present a compelling case to the bankruptcy court.
The petition should detail your current financial situation and explain why a bankruptcy is necessary. Only when you have exhausted all other options and have debt you’re unlikely to clear anytime soon will your filing be accepted.
We only recommend looking into bankruptcy if you’ve tried everything else, have debts that are destroying your life, and don’t have any home equity to help you dig your way to freedom.
Summary: A Low-Risk and Minimal Damage Option
Balance transfers don’t hit your credit score as heavily as debt settlement, bankruptcy, and many other forms of debt relief. It’s a quick, easy, and often painless way of clearing your debt, but getting a balance transfer card is just the beginning and you need to work hard from that point to make this process work.
If you’re not prepared to meet your monthly payments and pay extra where possible, this isn’t a good option. Be honest with yourself, assess your situation carefully, calculate how it will take you to repay your debt and whether you can achieve that goal within the introductory period. If not, you could be making your situation worse.