We’re all familiar with the idea of introductory rates. They are a good price that starts low to draw you in and jumps up later. This is common with internet providers, cable television, and credit card balance transfers. But, what if the fantastic deal stays in place indefinitely? There has to be a catch, right?
MoneyNing wrote about a variant of the 0% credit card balance transfer that I hadn’t seen before. Usually, the deal is that the debt transferred to the new card is charged no interest for a few months, and then the interest rate shoots way up.
There are two main ways people get caught with this deal. The first is that they are unable to pay the balance off before the interest rate shoots up and they have to pay excessive interest. The second catch is that if they use the card for new purchases, payments go toward the 0% balance and the new purchases start collecting high interest right away (although there is pending legislation to force credit card companies to apply payments more favourably for cardholders).
With a 0% for life balance transfer, we could beat the credit card company by just never using the card for new purchases. But that’s where the catch comes in. When credit card issuers offer 0% for life transfers, they require cardholders to make at least two purchases per month or else the interest rate would shoot up.
This could still be a good deal if the cardholder pays off the balance fast enough that the new purchases don’t accrue high interest for too long. To test this, I looked at the following scenario. Andy owes $5000 on a credit card. He is considering one of two approaches:
1. Use the 0% for life balance transfer. Andy will make two $20 purchases each month and make a $150 credit card payment each month until the card is fully paid off. We’ll assume that the interest rate on new purchases is 1.5% per month. (This is what the credit card companies would call 18% per year, but is actually 19.56% per year.)
2. Take out a line of credit for $5000. With the $150 available each month, Andy will make the two $20 purchases with cash and use the remaining $110 as a payment on the line of credit.
The question is what interest rate on the line of credit would cause the two debts to be fully paid off in the same number of months? It turns out that the credit card balance would be wiped out after 4.5 years. The equivalent interest rate on the line of credit that gets paid off after the same length of time is 5.7%. So, if the best rate Andy can get on a line of credit is more than 5.7%, he’s better off with the 0% transfer deal.
However, this analysis is very sensitive to the initial assumptions. What if Andy spends $100 per month and makes $200 payments? Then the credit card debt takes 5.5 years to pay off, and the equivalent line of credit interest rate is 10.6%. In this case, Andy is very likely better off with the line of credit.
Almost every special credit card offer is a potential trap to get you paying high interest on debt. Be wary.