Each month or quarter, I am inundated by offers for services by my bank, other competing banks, insurance companies, etc.. When our house insurance came up for renewal this month, the insurance company wanted more than 100 pounds more than they did the year before. I found a much more competitive introductory offer by our bank, for less than what we were paying. When I called to cancel, the company we were with was “willing to give us another quote” but I decided to go ahead with the bank.
Around the same time, I got a new credit card, with a lower annual percentage rate or APR, and part of the deal was an offer for a 0% balance transfer for X amount of time. Of course the trick was a 3% transfer fee for the balance of what you were transferring, which in my case, would be about 90 pounds. I decided NOT to do this, and instead, just focus on paying off as much of our credit card as possible every month, even if it meant paying a little bit of interest.
These two offers lead me to think, how do you know which deals to pick and which deal to stay away from? In both cases the “deal” is intended so that you will move your business over to the other bank and hopefully stay there, so that the bank can make more money long-term as they secure you as a customer.
The only economic condition under which you should utilize the balance transfer is if you are going to pay more interest than the transfer fee over the pay-back time period. This, of course, depends on how quickly you are going to get yourself out of the credit card debt. So the first thing to consider is:
- Will I spend more on transfer fees than on paying off the debt over the time period?
In addition to the economic condition above, however, there is another, more important behavioural consideration to take into account. For example, is moving the debt onto a 0 interest card going to change your future credit card consumption patterns in ways that make you worse off?
While this isn’t rocket science, I think this is where it gets important to be honest with yourself and your spending patterns. I know for me, having a relatively high balance will incentivize me to pay down my credit card faster, making larger payments, whereas moving to a low or 0% percent balance for a time period will give me time to pay off that debt with smaller payments, and meanwhile, I will feel more comfortable spending more on the credit card that is now empty post transfer.
I tried to find an academic article that showed this but what I found was an article by the financial conduct authority that summarized three different types of biases. Related to this post, the bias to worry about is Optimism bias.
Optimism bias refers to a situation where consumers are overconfident when assessing the likelihood of future events. The article states that “Consumers with more moderate levels of optimism have been shown to be more likely to pay off their credit card balances while extreme optimists have been shown to have preferences for credit card features that are inconsistent with their subsequent borrowing behaviour.”
So then the second thing you have to think about is:
2. Does transferring to a 0% interest rate change the level of optimism you have either about your future cash flow or your ability to check you future consumption patterns?
If you answer yes to either (or both) of these things, I wouldn’t move to the 0% rate. I suffer from optimism bias regularly. It’s important to realize that even if you do the math right, your future behavior can still be inconsistent with your financial health and it’s best to insure against that.
So, in sum, shop around for your home insurance but don’t play the transfer balance game if you don’t really need to and you think that optimism bias might play a role in how you are thinking about the decision.
