Using a balance transfer card to consolidate debt is not as popular as using a debt consolidation loan. It is not really surprising since it does involve the use of another credit card. The idea is to transfer all your existing debts into a new credit card to consolidate it. Since credit cards are notorious for their high-interest rates, this idea is not really appealing.
Debt consolidation loans, on the other hand, has a much lower interest rate compared to your existing credit card debts. It seems like the better option, right?
The truth is, both of these consolidation options are effective in their own way. You might be surprised to find out that using balance transfer is the perfect debt solution for you. If you have a huge debt problem, you owe it to yourself to explore all your options. You want to make sure that you are using the best debt consolidation strategy that suits your personal finances.
But how will you know which of the two should be chosen to get yourself out of debt?
How can balance transfer consolidate debt?
In order to choose between the two, let us define the process of consolidation for these debt relief strategies.
Debt consolidation loan
It is obvious how debt consolidation loans are used as a debt relief strategy. You borrow a loan that is big enough to pay off your multiple original debts. This can either be a secured loan (e.g. home equity loan), or an unsecured loan (personal loan). Once the loan is approved, you are just left with this one loan that you will pay off each month.
If you have mostly high-interest credit card debts, the low interest that is offered by these loans can save you a lot of money in the process of debt relief.
That sound really simple. But what about balance transfers?
Balance transfer card
When you use a balance transfer to consolidate debt, you will open a new credit card that offers the option to transfer your existing balances so you can pay it off with 0% interest (or at least a very low interest rate). You will be paying just one account each month and all your payments will go to the principal debt.
If you think about it, both of these options are practically the same. However, not everyone seems to be attracted to the debt relief possibilities offered by this strategy. One survey revealed that only 6% of Millennials are attracted to cards that offer balance transfer with 0% interest rate for 21 months. Either these people do not need to consolidate debt or they do not understand how that feature can save them a lot of money while getting out of debt.
Now that the similarities are identified, how are these two different from each other?
3 ways to compare balance transfer with debt consolidation loans
Understanding certain features of both debt consolidation loans and balance transfer cards will help you choose which of these can help your finances better. It is important for you to know important truths about debt consolidation options so you can make a smart decision about it.
This is usually the most important consideration of any debt consolidation strategy. Since there is no debt reduction on the principal balance, you can only rely on the interest rate for savings. Both balance transfer and debt consolidation offer savings on the interest but there are a couple of differences.
A balance transfer can offer as low as 0% interest. That is impossible to get with any loan that you will borrow for debt consolidation. However, the low-interest rate that you will get from debt consolidation loans is applicable throughout the repayment period. For balance transfers, it will only be effective during the promo period. This can be as short as 6 months or as long as 21 months. After that period is over, the card will impose a higher interest rate on any balance that is left.
This is the reason why you need to pay as much as you can while the 0% interest is still in effect. Ideally, you want to pay off all your debts before the introductory promo rate expires. If not, at least you should aim to pay a significant amount.
You should also remember that the low-interest rate in balance transfer cards is only for the transferred debt. If you use it for new purchases, the high-interest rates will apply.
Debt consolidation loans, or any loan for that matter, will charge processing or origination fees. However, lenders apply it differently. Some would ask you to pay the fees separately. Others will include it in the interest rate that you will pay over the course of the loan.
For balance transfers, the cost is based on the amount that you will transfer – usually 3%. So if you will transfer $5,000, you will pay $150 for the process to be completed. There are lenders who will ask for a fixed fee. Oftentimes, you need to pay this upfront but there is also an option to waive it. Of course, something has to give. Sometimes, people have to shorten the effectivity of the 0% interest so they do not have to pay the balance transfer fee. For instance, if the 0% rate is originally good for 21 months, it can go down to just 12 months.
Since it is also a credit card, there are other fees associated with it. This includes annual fees, finance charges for new purchases, etc.
Effect on credit
Finally, you need to check how both of these consolidation strategies can affect your credit score. According to a survey, one of the reasons why almost half of the respondents did not consolidate credit card debt is because they are afraid of how it can hurt their credit score. While both of these will have an effect on your credit score, it is mostly a positive one.
When you borrow a debt consolidation loan or open a new balance transfer card, it will lead to an inquiry on your credit report. This can pull your score down but it will only be a minimal change. However, as long as you pay off your balance, you will find a significant improvement in your credit score after a few months. You just have to make sure that you stick to your repayment plan and due dates.
With the knowledge that you now have of both balance transfer cards and debt consolidation loans, what do you think is more appropriate for you? Make sure to consider more than your ability to pay each month. Think about your financial goals and the type of debt that you owe. Aligning these with your debt relief goals should help you figure out the right debt consolidation strategy to use.