Doing a Balance Transfer? Don't Be Alarmed if This Happens

Among the pantheon of scary emails you could receive, learning that your credit score has plummeted by 61 points in a month has to rank highly. After all, your credit score is a pretty significant part of your personal finances, and a lower credit score means paying more to borrow money, in the form of a higher interest rate -- assuming you can even be approved at all.

I know someone who recently experienced this. He had a dramatic 61-point drop in his credit score, but while it was a bit of a shock at the moment, he knew why it had happened. Here's how transferring a credit card balance can hit your credit score hard -- and why it's ultimately nothing to worry about.

Credit scores 101

You probably don't think about credit scores all that often, unless you are also a personal finance writer (in which case, hello!). In case you've forgotten or just never knew, your credit score is based on several different factors that are weighted in different ways.

Generally, when we talk about credit scores, we're specifically talking about FICO® Scores, which are used by 90% of lenders when deciding whether to loan you money (and at what interest rate). FICO® Scores range from 300 to 850, and are based on these five factors:

1. Payment history: 35%
2. Amounts owed: 30%
3. Length of credit history: 15%
4. Credit mix: 10%
5. New credit: 10%

In the case of a balance transfer, it's "amounts owed" that we're concerned with. For credit cards and other revolving debt (meaning you can consistently borrow and repay a line of credit), it's important to keep your credit utilization ratio (the amount of credit you're using) low. It's recommended to keep this number below 30%.

So if you have a credit card with a $10,000 credit limit, you should ideally be carrying a balance of no more than $3,000 at any given time. If you use more credit than this, you'll risk credit score damage. A higher utilization ratio could indicate that you're living above your means or having difficulty managing credit, both of which are red flags to lenders.

A balance transfer's impact on your score

Balance transfer credit cards can be a great way to pay off debt without incurring additional interest charges (assuming you have a plan to pay the card off in full before your 0% APR period ends, that is). But they can impact your credit score in a few ways.

First, you could see a small credit score drop after you apply for a new balance transfer card, because the lender will perform a hard inquiry -- this results in the loss of a few points. But you could see a big drop because of how balances are reported to the credit bureaus by card issuers. Your balances are reported every month -- but different issuers report at different times.

Let's say you move $3,000 from one credit card to a new card with a different issuer. (Note: you generally won't be allowed to transfer a balance to a card with the same issuer to skip out on paying interest on that balance you owe; you'll need to apply with a different issuer.)

But your previous balance on the old card was just reported to the credit bureaus, and your new card issuer reports that you've got a new card with $3,000 charged to it. Uh-oh. Now your credit utilization ratio is up, and to the credit bureaus, it looks as if you just went on a $3,000 spending spree. Hence, your credit score plummets.

But have no fear! Your score will recover. In the case of my friend, his score bounced back up the following month, once his old card issuer reported the now-$0 balance on the card he transferred the balance from. If this phenomenon happens to you, take a deep breath and know that your lower credit score isn't forever.

One word of caution

It pays to be careful about when you move a credit card balance to a new card, because of the potential for a big temporary credit score hit. Let's say you're transferring a balance, and also intend to apply for a car loan soon. If your credit score hasn't recovered by the time you apply for that loan, you could find yourself facing a higher APR on the amount you're borrowing.

As such, it's a much better idea to finish any credit card balance transfers well before you intend to apply for a loan of any kind. If you're borrowing money, ensuring your credit score is in the best shape possible beforehand will save you money. Keep this in mind, and if you see a big credit score hit after transferring a credit card balance, rest assured that your score will recover soon.