When you are carrying a balance on a high-interest credit card, receiving a 0% balance transfer offer can be enticing. After all, shifting the balance from a high-interest credit card to a no-interest card means saving money on interest and paying down the balance faster.
But how will the balance transfer impact your credit score?
First, you should understand three crucial elements that go into determining your credit score: inquiries, credit utilization, and length of credit history.
- Inquiries – How many new accounts have you opened lately? Whenever you apply for new debt, the lender performs a “hard inquiry” to determine whether they will approve your application. According to FICO, hard inquiries account for about 10% of your credit score.
- Credit utilization ratio – How much do you owe? Your credit utilization ratio is calculated based on your total outstanding balances compared to your total credit limit. It is calculated both per card and across all of your credit accounts and makes up about 30% of your credit score.
- Length of credit history – How long have you been using credit? This factor looks at the age of your oldest account as well as the average length of all of your credit accounts. The longer your history, the higher your score. According to FICO, the length of your credit history accounts for about 15% of your credit score.
How balance transfers can hurt your credit score
Balance transfer applications count as a hard credit inquiry
When you open a new account for a balance transfer, the lender will perform a hard inquiry. One hard inquiry is unlikely to have a large impact on your credit score. If you have excellent credit and haven’t applied for a card in the last six months, one hard inquiry may not impact your score at all. Inquiries could have as much as a ten-point impact, but that would be very rare. The typical impact of one hard inquiry is about five points. However, if you apply for several cards at once, the applications could have a big impact.
Balance transfers lower the average length of your credit history
Opening a new credit account will lower the average age of your credit accounts, which can negatively impact your credit score in the short term.
For example, if you have one 5-year-old credit card, one 3-year-old credit card, and one 10-year-old credit card, the average age of your cards is 6 years.
When you open a new credit card for a balance transfer, you now add a less-than-one-year-old account to your balance. At the most, your average credit age will drop down to 4.75 years.
How balance transfers can improve your credit score
All in all, the benefits of balance transfers can far outweigh the negatives.
You will likely lower your utilization rate
Opening new credit accounts decreases your overall credit utilization ratio, which positively affects your credit score over time. For example, if you have one credit card with a $5,000 limit and a $2,500 balance, your credit utilization ratio is 50%. When you open a second account with a $5,000 limit and transfer the $2,500 balance to the new card while leaving the old account open, your total available credit is $10,000 ($5,000 + $5,000), and your outstanding balance is still just $2,500. You’ve reduced your credit utilization rate to 25%.
What happens if the new account’s limit is just $2,500 and you transfer the full $2,500 balance? You’ve still reduced your overall credit utilization ratio. Now you’re using 33% of your available credit ($2,500 / $7,500). However, the negative is that there are still some points taken away if you max out one card. You didn’t have any maxed out cards before, and now you do. Credit scores are very sensitive to people who max out their credit cards as they’re seen as high risk. Maxing out a new card could reduce your credit score by about 30 points in the short term.
You will be paying off debt faster, improving your score dramatically
Where balance transfers get exciting is that more of your money is going to paying off the balance of your debt as opposed to interest. Ultimately, the best credit score comes from carrying as little debt as possible.
Using our previous example of the $2,500 balance on one card, assume that card had a 21% interest rate and you could afford to pay $220 per month toward paying it off. According to MagnifyMoney’s balance transfer calculator, if you did not take advantage of a balance transfer, the card would be paid off in 13 months, and you would pay $309 in interest. If you transferred that balance, even with a 3% balance transfer fee ($75), you could pay off that balance one month sooner and save $234.
In the end, your goal should be to pay off your debt as quickly as possible. Over the course of a year, as long as you stick to your strategy, you can eliminate that debt in a year, and your score will go up a whole lot faster than it otherwise would.
When to avoid balance transfers
The short-term impact of a balance transfer on your credit score should only concern you if you are planning on applying for a mortgage in the next six to nine months. During this period, every point on your score counts. Just a 0.2% difference in your interest rate can cost a ton of money over the life of your mortgage. In that case, wait until after you get the mortgage to do the balance transfer.
The bottom line
People are so programmed to think about their score that they sometimes lose sight of what they want the high score for. A higher score saves you money and gets you out of debt faster. Don’t focus on short-term fluctuations of 10 to 20 points. Use your good credit score to save money. That’s what it’s there for.