When debt accumulates you might think about turning to your credit card to alleviate the burden of high interest rates, but does it actually make sense to pay off debt with more debt?
In many cases it is technically possible to pay off a car loan with a credit card — whether or not it is good for your bank account is another story. Moving a loan to a credit card is a method of garnering a lower APR through a process called “balance transferring.”
Why consider using a card to pay off your car loan?
A balance transfer is when you transfer a car loan or existing card balance to another credit card. This process sometimes comes with added fees, and on face value may seem like passing the buck (literally), but there are some practical reasons for balance transfers.
For example, if you have significantly improved your credit recently and qualify for a low interest credit card, a balance transfer is a way to reduce monthly payments.
When it comes to addressing debt, the idea is that by simply “paying off” a car loan with a low or no-interest credit card borrowers are only left to worry about the principal.
This is a common way for individuals to work around high monthly payments on low-risk debt such as car loans. Essentially, by moving debt to a credit card, ideally one with 0% interest, the auto loan will be paid off in full and you will forgo interest payments.
Sound too good to be true? Well, it is. While the prospect of managing debt on a credit card might seem appealing at first, there are several financial pitfalls that come with swiping your card to pay off auto loans.
The Hidden Costs of Balance Transfers
In theory, transferring the debt to a low interest card could result in huge savings. However, when you perform a balance transfer you aren’t actually paying anything off — you’re merely relocating debt from one pocket to another. The overall balance will not be reduced at all, and you will not avoid any interest costs that were already incurred.
Balance Transfer Fees
A balance transfer can reduce future costs by capitalizing on a low APR card, or introductory 0% interest promotion, but this comes at a cost as well. Generally, you will face upfront costs of 3% (or more) of the total balance being transferred. This means what seemed like a simple savings measure actually involves an expense that you may not have accounted for.
0% Introductory APR
Remember that all good things must come to an end. Low rates usually don’t last with balance transfer credit cards. Many people will look to 0% APR cards to pay off an auto loan, pat themselves on the back for cheating the system, and call it a day — but not so fast.
A no-interest card may seem like the answer to your financial prayers, but remember this rate is usually a limited time offer.
Promotional rates usually only last 6-21 months, so before charging a big-ticket loan to a credit card make sure to evaluate whether or not you will be able to pay off the balance in the allotted window. If the auto loan balance carries over after the promotion, you will be in big trouble.
Standard APR Credit Cards
Student loans, a common debt that many people look to offset with the aid of a credit card, are normally lent at a 7% APR. After refinancing, this rate can drop to as low as 3%. The average credit card APR is 15%. You don’t have to be a math whiz to recognize that moving debt to a standard credit card, without the crutch of a promotional low APR, will nearly double interest payments.
Regardless, some people decide to move loans to credit cards that have standard interest rates, and incur the added cost, in order to reap benefits like airline miles, fuel points, etc. Simply put: this is a horrible idea. Interest this high, on a large balance, will bury you. Unless you plan on hitting the lottery soon, avoid delegating debt to a higher APR than what you borrowed it at.
Moving Debt to Credit Cards Will Affect Credit
Before moving a large sum to a card you should consider the effect it will have on your personal credit.
Credit Utilization Ratio
Building a credit history through card use and on-time payments is an important part of boosting your credit score, but borrowing too much money can result in negative marks. Credit utilization ratio (CUR) is a measure of how much money you owe versus the total potential debt you could incur. This metric derives from a simple equation:
Credit you’re using / amount of credit available = CUR
This number is an important factor in your overall credit score. It is recommended you only use 30% of your allotted credit to maintain a healthy FICO score. Put simply, borrowing too much money, even if it is within your credit limit, can negatively affect your credit score.
With this in mind, moving a large auto loan balance to a credit card will likely ding your credit score due to passing the recommended 30% borrowing threshold.
Technically, if you were to charge a loan to multiple cards you could avoid this issue. However, it is a little overly optimistic to expect to have multiple 0% APR credit cards at your disposal, and it makes no sense to move debt to a credit card that has a standard APR.
Moving from Secured to Unsecured Debt
Transferring a car loan to a credit card also comes with a greater risk to your personal finances if you happen to lapse on car payments. If for whatever reason, money is tight and car payments start coming in late, you will experience a huge blow to your credit score.
Credit cards are “unsecured loans” which means they are not backed by collateral. If you experience unexpected financial hardship after moving a loan to a credit card there will be no asset to repossess, and your credit score will surely take the brunt of the fallout.
So what should you do instead?
In general, it doesn’t make much financial sense to pay off debt with more debt. If you’re looking to decrease a car loan’s impact on your bank account, you’re probably better off re-evaluating your finances from the ground up. There is no “secret” to getting right side up on auto loans, and incurring more debt is not the answer.
Instead, think about establishing a budget and exceeding minimum payments. This way you will dig yourself out of debt sooner. Also, refinancing is a good way to decrease the financial burden of interest payments. Seeking out credit repair services can help you regain control of your FICO score, and once you do, you can refinance at a lower interest rate.
We are led to believe credit cards are a magic wand — an inexhaustible bank account — that can fix any financial issue. This is simply not the case, so be wary of paying off loans with credit cards.
As an alternative, consider addressing the root of financial hardship and reestablish yourself through tried-and-true measures such as budgeting and credit repair rather than rolling the dice on incurring additional debt.