Thursday, April 30, 2009

How To Use A Credit Card As A Debt Consolidation Loan

My last post about how to avoid debt consolidation loans got me thinking about using credit cards as a way to reduce the number of creditors you are paying as well as reduce the amount of interest you pay out each month. This is a viable strategy that a lot of people use even if they aren't in a lot of debt. It has several different names that it commonly goes by on the internet and among financial professionals, like credit arbitrage and balance transfers, but the principal is the same: reduce debt interest rates by moving your money around to a new debt holder.

The Holy Grail of credit cards are the 0% balance transfers that were about as common as grass a couple of years ago. I'm not sure if they are as prolific now as they were then (I removed my name from some list to stop the flood of credit card offers I was receiving in the mail), but if you can get one they can really help you reduce the amount of money that you owe to your creditors by making more of your interest payments go to your debt principle.

As always let's take a look at an example. Right now I have an outstanding balance on my Chase Freedom Rewards Credit Card of $417.23. I never carry a balance month to month, but if I did my monthly minimum payment would only be $10. Right now my interest rate on this card is 13.24% APR. If I were to only make the minimum payment of $10 a month it would take me a total of 56 months to pay off the card.

If I were to transfer the balance of this card via a 0% APR balance transfer I would be able to pay off the card in 42 payments. That is a difference of over a year!

Now this example is not very realistic - who would only pay a $10 minimum payment on a debt of $400? Most people who suffer from lots of consumer debt normally have it spread out over several different debt services and at various interest rates. Can a credit card really be used as a way to reduce this type of debt effectively? What if you can't get a 0% APR balance transfer, is it still worth it?

Consolidating Multiple Sources of Debt On Credit Cards
I do not have too much experience with this one, but I imagine that if you can pay your monthly bill with a credit card then you can "transfer" your debt to your credit card. All you would do to transfer the debt is to charge the entire balance that you owe to your credit car.

This is certainly not without risk. I'm not sure if you are aware of this, but credit card companies can change your rate at any time, for any reason. So let's say that you just got a brand new card from American Express with a balance of $10,000 and an introductory 0% APR for the first 12 months. You decide that paying 0% interest is better than paying 7% interest on your car loan (which it is) so you transfer the $7000 remaining on your car loan to your credit card.

Now if the credit card company doesn't do anything to you you just saved a bunch of money on interest payments if you can pay off the debt by the end of the 12 month introductory rate. You will have saved $270 in interest.

But what if your credit card jacks up your rate to the normal 13% just because they feel like it? You end up paying a lot more interest than if you had just paid off your auto loan normally.

You might want to contact your credit card company to see what their policy would be if you did this to make sure it will fly before you risk that type of cash. Ask questions, get information, and be wise about doing something like this.

Transferring Multiple Credit Cards to Consolidate
This is pretty easy to do and is a lot like the example above, except that it can have less risks if you are aware of the cards "fine print." Most teaser rates are designed to steal credit card customers from other companies, so they have forms that you can fill out to easily and simply transfer balances from one card to the next. If for some reason your new card doesn't have one of these forms then you could always just use the method I stated above, but you will be assuming all the risks.

Knowing your card's "fine print" is incredibly important if you are going to use your credit card as a debt consolidation loan. You have to do it and you have to be certain you know what it is saying. A mistake here can cost you hundreds of dollars.

Balance Transfers To Just Pay Lower Interest
Is it good to simply transfer debt to a lower interest credit card, even if it isn't pegged at 0%? I think the answer to this is yes, but the amount saved depends on the interest rate and the amount of debt that you have. The more debt you have the more a small change in interest rates will save you, but if you only have a $1000 of debt that you will pay off in a year, then the difference between a 4% and 7% interest rate is only going to be about $17.

If the balance is $10000 and the term of the loan is 5 years then the amount saved by going from 7% to 4% will jump to $830, about $166 a year in savings.

The Debt Snowball And Credit Card Consolidation
Probably your best bet at quickly and effectively paying off your debt is to use a debt snowball technique. I am a fan of paying off the highest interest debt first since this will get you out of debt fastest and will have you pay the least amount to your creditors. Here are the main steps of the debt snowball:
  1. List all your debts in order of the highest interest rate first and the lowest interest rate last
  2. Transfer as much of your high interest rate debt to lower interest rate sources
  3. Pay the minimum payment on all your debts and throw as much extra cash as you possibly can at the highest interest rate debt
  4. Once that is paid off, take all the money that you were paying on the highest interest rate debt and use it to pay off the next highest interest rate debt
  5. Continue this process until all your debt is completely gone
This method is proven to pay off debt quickly and efficiently and all major financial experts that I know of recommend a version of the debt snowball method.

So credit cards can be an effective way of creating your own debt consolidation loan and can help expedite your journey toward debt freedom if used wisely and according to your card issuer's terms and conditions.