Balance transfers are one of the most effective ways to lower the cost of your credit card debt. Where else can you access a 0% interest rate for 12 months? However, there’s a right way and wrong way to do a balance transfer.
Do it the wrong way and credit card issuers have a sneaky trick that can cost you more than you think, even if you’re making your payments on time, every time. Do it the right way, and it’s as good as it looks.
Here’s the rub. People get into trouble when they transfer a balance and make new purchases on the same credit card. The reason why that’s a problem is because of the way credit card issuers allocate your payments. It’s always best to keep your balance transfer credit cards separate from a credit card you use for purchases. Here’s why:
Proportional Payment Allocation
When you make a credit card payment, your credit card issuer has a choice of how it can allocate your payment among the various balances on your card. For example, on one card you may have a balance of 0% from a balance transfer, 19.9% from a purchase and 24% from a cash advance.
Your credit card issuer, can then choose to allocate your payment to your highest interest rate balance first, to your lowest interest rate balance first, or proportionately based on the size of each rate’s balance. Each methodology has different cost implications for the cardholder.
In general, in Canada, if your credit card account consists of balances with different interest rates, such as purchases at the standard interest rate and cash advances at an introductory or promotional interest rate (e.g. a special lower rate balance transfer or a temporary lower rate on all cash advances), any payment that exceeds the minimum payment due will be allocated to those balances in a proportionate manner.
Your payment will not be applied to the balance of your choice, such as the balance with the highest interest rate. For example, if your balance from purchases at the standard rate is $700 and you have a balance from a cash advance of $300 at a 0% promotional interest rate, proportionate allocation means that 70% of your payment will be allocated to your purchase balance and 30% will be allocated to your cash advance balance.
Of course, you would rather 100% of your payment be applied against the balance with the higher interest rate, so that the balance declines faster, paying less interest, costing you less.
With proportional allocation, the only way for you to get rid of your high interest balance, is to pay down your low interest balance completely. However, if your low interest balance is high, which most promotional rate balance transfers typically are, your high interest balance will be “conserved” as the banks call it, until your low interest balance is paid off.
The more low interest balance you put on the card, the longer the high interest balance lasts! It’s counter intuitive, but it works. The good news is, it’s really easy to avoid.
Beating The System Is Easy
So how can you regain control of your payments so that you pay down your highest interest balance first? The answer is actually pretty simple. Use one card for balance transfers only, and another card for purchases only. You then determine how much of one balance you want to pay down versus the other, allocating the payments to each card yourself.
If you’d like to transfer a balance, get a 0% balance transfer credit card like the MBNA Platinum Plus MasterCard with an always on balance transfer promotion of 0% for 12 months. Never use that card to make a purchase, only use it for balance transfers.
Alternatively, you can keep a no fee low interest credit card in your wallet at all times. You can then transfer balances to it when need be, without having to worry about applying for a new card.
Either option works, although 0% will be cheaper than any low interest credit card rate.