Why Balance Transfer Offers and Cash Rewards Don’t Mix

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Twitter Credit Card Rates Balance Transfer: 12.40% Low Interest: 12.17% Cash Back: 12.49% Business Cards: 10.74% Instant Approval: 17.62% Student: 14.71% Travel: 14.17% Updated: 01-25-2009

Two of the most sought after credit card features are 0 APR balance transfers and cash back rewards. Over the past several years, these features have proven so popular that virtually every major credit card offers one or both of them. And it’s those cards that offer both a balance transfer and cash rewards features that are the focus of this article. While both features have value, using them together on the same card at the same time can be financially disastrous. We’ll take a quick look at both balance transfer offers and cash back rewards, then we’ll cover why using them together on the same card can cost you a truckload of money. Finally, we’ll look at what you can do to protect yourself and pending federal legislation that may eliminate the problem.

Balance Transfer Offers–The Basics

Credit cards with a balance transfer offer allow cardholders to transfer high interest rate balance from other credit cards. Most offers charge no interest for a period of time, usually six to 12 months. You do have to watch out for balance transfer fees, which typically run about 3% of the amount transferred. But even with the fees, a balance transfer can be a good deal, particularly when compared to credit cards that charge 10%, 15% or even more.

Cash Reward Offers–The Basics

As the name suggest, cash rewards pay cardholders cash based on the purchases they make. Some of the best deals pay as much as much as 5% cash back, such as the Discover More card. While some cards offer introductory cash back after a certain amount of purchases, almost all cash back rewards card pay rebates each year based on purchases made with the card. Some cash back offers apply to all purchases, while others apply to only certain purchases (e.g., gasoline and groceries).

Why Mixing Balance Transfer and Cash Back Offers is a Bad Idea

When a credit card offers both a balance transfer and cash back feature, it might be tempting to use them both at the same time. For example, you might transfer $5,000 of high interest debt to the card, and then continue to use the card for purchases to take advantage of the cash rebates. You might even plan to pay off the purchase balance each month to avoid finance charges, but that’s where the problem arises.

Most credit card issuers today apply payments in the following order: 1) outstanding interest, 2) low interest balances, 3) higher interest balances. In other words, the principal part of your payment will go to pay down your zero percent balance transfer, not the purchase balance subject to higher interest rates. In fact, once you make even one purchase on the card, that purchase balance will stay on the card accruing interest charges until your balance transfer is completely paid off!

Because of this trap, I never carry my balance transfer cards with me. In fact, I normally cut them up so there is no chance of using them by mistake.

Congress to the Rescue

Recently the Federal Reserve approved regulations that would change all this. Under the new rules, credit card companies must apportion payments equitably, such as apply the principal payments in equal amounts to both the balance transfer and purchase portion of the outstanding balance. Unfortunately, these new rules won’t go into effect until the middle of 2010.

It is likely, however, that Congress will enact new legislation this year that accomplishes the same thing. Until then, however, one way to deal with this is to apply for one card to handle balance transfers and a second card for daily purchases.