APR

In part 1 of this series, I wrote about how much money you would potentially save by making use of a 0% APR balance transfer (BT). At the time, I was expecting to write part 2 about how to make use of a balance transfer when you don’t have any credit card debt. However, I will now cover that in part 3 and address the issue of balance transfer fees in the current part. This part will attempt to answer questions like: Is a balance transfer worthwhile if the credit card charges a fee of 3%? How much would I earn in this case? At what point do the fees become greater than the gains?

We will consider the same scenario again: you have a 0% APR offer for 12 months on your new card and you want to save money by transferring your balance from a card that is charging you a 10% APR to this 0% card. But, unlike the last time, your new card is charging you a 3% BT fee. Usually there is an upper limit on the fees (usually $75, sometimes $100). Let us see what happens in this case.

How much would you save?
Let us assume that you were planning to pay off the balance on the 10% APR card uniformly over a period of one year. Last time we saw that if you have $5000 on your 10% card, you could save about $280 ($275.2 to be exact) over a 12 month period. However, with the fees (for $5000 it will be $75), your savings will be about $200. The savings are graphically shown below for all amounts from $500 to $5000.

Lessons from the graph are:

1. For small amounts the gains are very small even without any fees. With fees they can be extremely small (read: not worth the trouble). For example, for $1500 transferred with a 5% BT fee, you will save only $7.56 ! ….yeah fees are never good :). If I were to use such an offer, I would be interested only if my balances were above $2500.
2. Since fees are capped at a maximum of $75, savings for both 3% BT fees and 5% BT fees are same for higher amounts.
3. There is another catch with transferring smaller amounts. The savings shown in the graph above are after assuming that you will take the full 12 month advantage of the 0% APR offer. However, if you are looking to transfer smaller amounts, you might be better off by just paying them off on your old card in a couple of months. For example, look at the graph below.

4. 

   It shows you the savings per month when you transfer $500 from a 10% APR to a 0% APR card. There is a 3% BT fee ($15). It is clear that the savings are more than the fees ONLY if you cannot pay off the balance for more than about 6 months. So if you can make payments of about $84 a month, I would suggest paying the $500 off instead of using the balance transfer offer. I know it is getting a bit complicated here but make sure you understand the implication of BT fees; read this stuff three times if you want to :).

5. If you are looking to transfer about $5000, then look at the graph below.

   

   Clearly, the savings become more than the fees after the first two months. Now, a balance transfer with fees will make sense this case because (normally) it is highly unlikely that you will pay off $5000 on your 10% APR card in two months.

I am summarizing a crude rule of thumb (Golbguru’s Balance Transfer Rule if you like :)) you can use:

-Don’t bother yourself with a 0% BT offer, that charges fees, unless you are looking at about $2000 to transfer. If your current card charges an exhorbitant APR (like 20% ~ 25%), again don’t bother unless you intend to transfer at least $1000.

There is another way of looking at balance transfers: you use one credit card company’s money to pay another credit card company, while you can keep your own money in a high-interest account. If you go through all of the above with this logic, you will reach the same conclusion.

Please feel free to share any experiences/cases where you feel this line of thought does not apply.

Ok so you have a 15 month 0% APR offer, how are you going to squeeze the best out of it? In one of my previous post the title says “Free Money..“. Where exactly is the free money involved? Am I talking about all the interest you will save by paying only the minimum required instead of clearing off everything on your card every month? Absolutely not! Here is how you go about it and how much you will earn from such an offer.

I will divide this into a two part explanation. Part 1 below will deal with how to use such an offer if you have balances on other cards (or carry debts). In a couple of days I will post Part 2 which will explain how to use it if you don’t have any balances on other cards (or you are essentially debt free).

How to do it if you have balances on other cards?
If you application is approved for a card that gives you a 0% balance transfer offer, avail the offer immediately. Sometimes this facility is offered during the application process and allows you to enter information for the cards towards which you want this balance transfer to be applied. Give priority to the cards that are charging you high APRs (giving priority to cards that carry lesser balances and/or lower APRs for “mental satisfaction” doesn’t make any financial sense to me). If you are not able to do this during the application process, call up the credit card company and do it over the phone. This will work for most credit card offers. At times, you can request a check for the balance transfer amount instead of directly transferring to other credit cards. This is convenient if you have debts that are not on credit cards.

How much will you save?
To simplify matters, let us assume you have a card that’s charging you a 10% APR and you have a balance of $5000 on that card. If you plan to pay off this balance uniformly over a period of 15 months, it works out to approximately $356 per month. By the time you finish paying this off, you will have paid a total of about $5340 ! that’s $340 more than what you owed. If you pay off this $5000 debt using 0% APR offer, you will save about $340 !
If you consider repaying $5000 over a 12 month period in a similar fashion, you will need to pay about $440 per month. That works out to $5280 by the time you pay it off. So applying your 0% balance transfer in this case will save you $280.

To estimate your total payments use this calculator from Bankrate.com

Very important things before you get into this:

-Never use such offers to borrow more than you can pay off within the offer time period. In the above example, get $5000 from the offer only if you can pay it off completely in the 15 months (or whatever you offer time span is). Always check the regular APR that is applicable after the offer time period. If this APR is very high and if you don’t pay off the entire amount immediately after the offer ends, your savings can disappear quickly.

-Make sure you are never late on the monthly payments. You miss one monthly payment and your 0% APR will vanish before you can blink. You need to get organized if you want to play this 0% APR balance transfer game.

-Always read the fine print. Check if there are fees involved with the balance transfer offer. Most offers will not impose fees on the first balance transfer. However, some cards don’t allow it for free and will charge a 3% fee . Usually, there is a maximum limit on this fee ($75 ~ $100). I will write more about this in time to come.

-Always check if you purchase APR is 0% for the offer period. If it is not 0%, then never use that card for regular purchases till you completely pay off all the balance you transferred. Payments are always applied to lower APR charges first. If purchase APR is 0%, then go ahead and use it for purchases but keep an eye on how close you are to the credit limit.

Another chance for earning free money with this credit card: Blue from American Express.
There is no balance transfer fee.
Here is what it says in the fine print:
“There is no balance transfer transaction fee associated with this offer. However, future balance transfers may incur a fee as disclosed at the time of the applicable offer or transaction”Other highlights are no annual fees and the 0% balance transfer is valid for 15 months (!) instead of the usual 12 months.

The APR is declared to be between 12.24% and 19.24%, depending on your credit history.

[Do let me know if you have seen the calculations behind the "Rule of 72" before this :)]

I am sure almost everyone on the personal finance blogging scene must be knowing about this rule of thumb…sort of. Here, I am just revisiting the idea behind this deceptively simple concept from ground up.

This is the “Rule of 72″: to quickly estimate the number of years it will take your initial invested amount to double, just divide 72 by the interest rate. For example, if your interest rate (APY APR) is 12%, the time it will take to double your investment is 72 divided by 12 equal to 6 years.

So is this rule applicable to all interest rates?

For the mathematically inclined, here is a check on how accurate this rule is (If you have an HSBC Direct or Emigrant Direct or ING Direct account and are not interested in the math just scroll towards the end of the article:) )

We start with the compound interest formula:

Where, P is the initial investment, A is compounded amount after t years, r is the rate of interest in decimal form, n is the number of times the interest is compounded in a year.

For simplicity, we will assume n=1 (I will discuss what happens when n varies from 1 to 365 in a later post).

Now, we are interested in doubling the amount so we substitue A=2P in the above formula to get:

We now take logarithm of both sides of the equation to get:

Then, t can be written as:

Now, the rule of 72 says:

(Note: Here r is in %, not in decimal form; in decimal form it will be 0.72/r). We have to check if the expression we derived for t above evaluates to 72/r. In other words, we can check if t multiplied by r gives us 72.
There is no easy way to do this, so I will explain it graphically. From our expression for t we can write:

We are going to check if this “Factor” turns out to be 72 (Note: in this last logarithmic formula, r must be in decimal form. We will then multiply the result by 100). Below is a graph drawn using the above equation and shows the relationship between the “Factor” and interest rate %.

We can easily observe from the graph that the factor 72 is not constant ! that means the rule is valid ONLY for one particular interest rate !! The factor of 72 is valid only for a rate of 7.8% !

However, since most of the investments are within the shaded region shown on the graph, the number 72 works for us as a rough estimate.

And now it’s show-me-the-money-already-damn-it time
For those of us who have accounts in HSBC Direct and Emigrant Direct, the rule is more like “Rule of 71″ and you will double you initial investment in about 14.3 years and 14.1 years respectively (now they will be same, read about it here on Blueprint for Financial Prosperity), at their current rates of interest. If you bank with ING Direct, the rule is more like “Rule of 70.8″ and you will double your money in about 16.4 years. Keep in mind that these are estimates and that we made some assumptions above (like n = 1) so the real numbers will vary a bit.

Now hopefully, after the above calculations, some of you will look at the “Rule of 72″ with a little more respect in future :).

Feel free to point out any mistakes or suggest improvements to the calculations above.

Yeah 1303.57 % APR !! that’s right, it’s NOT a typo ! Woah….initially, I thought somebody mispoke or I misheard or something, but then I did some research and found out people/websites who were offering something similar. Here is the link to the 1303.57% APR lending website. Here, here and here are more links to ridiculous interest rates…one of them even has a 1460% !

In fact the lenders don’t even try to hide the APR under the guise of some crappy fine print..it’s out there for everyone to see (I think there is some kind of a APR disclosure requirement, but I am not sure). And yet this doesn’t seem to scare a lot of people out of this payday loan stuff.

The irony is that these loans, at such unaffordable rates, are being offered to the very people who have run out of money before their next paycheck. The likelyhood that these people are living paycheck to paycheck, and will probably find it difficult to repay the loan with their next paycheck, is very high. Those who do not live paycheck to paycheck are very likely to have some remaining balance from the last paycheck and hence don’t need to borrow from these lenders. Of course, I am excluding the possibility of a really genuine disaster; but I will not be surprised if such genuine events are negligibly small compared to the number of people who avail payday loans.

Where do these ridiculously high APR numbers come from?
Payday loans charge fees per $100 borrowed per week. So if you are charged $25 on a $100 loan, for one week, how much would you pay in fees if you keep the $100 for a year? That will be simply $25 multiplied by number of weeks in the year (about 52.17); this calculates to about $1304 which is 1304% of the $100 you borrowed. Click here for a calculator to see how fees and terms translate into APR.

Other options to payday loans
If you get caught in an emergency situation, before you even think of a payday loan, consider these options.
1. If possible, charge the emergency expense to your credit card. (Costs: Purchase APR about 10% ~ 15%)
2. If you need cash urgently and if you have only credit cards, you can use them at ATM machines to get a cash advance withdrawal (Costs: about 25% ~ 35% APR, no grace period).
3. Some cards like Discover allow cash back transactions (Costs: Purchase APR)
4. Borrow from a good friend (Costs: A home-cooked meal or two; however the wise recommend that money and friends should not be mixed…sometimes the cost might be friendship)

If none of the above options work and payday loan is your last resort, then keep this in mind:
1. Read loan terms very carefully (you can get sued for not repaying on time).
2. Borrow as small an amount as possible.
3. Keep the borrowing term as small as possible.

Resources:
1. Federal Trade Commission: “Payday Loans = Costly Cash”
2. Bankrate.com: “Officials call payday financing “loan sharking””
3. PayDay Loan Consumer Information