Monday, January 19, 2015

pros and cons of rewards cards

"My general rule of thumb is the harder a company tries to sell me, the more the transaction will favor that company while I end up with the short end of the deal (anyone ever sit through a timeshare presentation?) And credit cards are advertising hard. Does that mean there's a hidden catch?"

Credit card advertising is more prevalent than just about anything else (maybe cars, maybe beer?) - they're everywhere. And they're pitching rewards more than ever before: "the card that pays you back", "double miles", "no hassle miles", "the card that pays you twice", and on and on..

But, just because these ads are omnipresent, should you participate?

My general rule of thumb is the harder a company tries to sell me, the more the transaction will favor that company while I end up with the short end of the deal (anyone ever sit through a timeshare presentation?) And credit cards are advertising hard. Does that mean there's a hidden catch?

Before we talk pros and cons, let's take a look at some factual information about how credit card companies make money. Once we understand where they're coming from, it's easier to see the benefits and drawbacks to using them.

5 ways credit card companies make money

Transaction Fees. Every time you swipe your card for a purchase, anywhere in the world, the credit card issuer gets to keep a small fraction of the purchase price. This transaction fee is their compensation for facilitating the purchase of goods. You and the seller both get the benefit of not having to exchange exact cash (or barter with chickens and wheat), and you're willing to pay a small fee for that convenience.

Spend $4 on a Venti latte, and they earn a few pennies. Spend $3,000 on a big screen tv, and they earn some dollars. Get a few million people spending a few thousand dollars per month, and it adds up to lots and lots of dollars.

So, even if no other fees were ever paid, and everyone paid on time and in full every single month, the credit card companies would still be earning lots of money.

Annual Fees. Some credit cards charge you an annual fee for using their card. This may be based on your credit score, or the rewards program, or some other exclusivity. The convenience of easy transactions is enough of a benefit that consumers are often willing to pay that fee.

* Get 25 million people to pay a $40 annual fee, and you've got yourself a billion dollars. Yes, annual fees are big money.

Interest on Loans. Credit cards are loaning you money, and like all loans you will need to pay interest on the money you borrow. This is after the 20-25 day grace period, meaning if you pay them back within a couple weeks they won't charge you any interest.

There are many people who never have to pay interest on their credit cards; they simply pay their balance off in full every month. Unfortunately there are many many many more people who carry a balance on their credit cards, which allows the bank who issued the card to collect interest on that money.

* Get 15 million people to carry a $5,000 balance at 12% per year, and you're making $9 Billion. Yes, that billion with a B. Interest on credit card balances is gigantic money.

Late Fees. Once a consumer starts carrying a credit card balance, the credit card companies are in a win-win position. The cardholder will either make a payment on time each month (which allows the bank to collect their interest payments on a nice, fixed schedule), or he won't pay on time, which allows the bank to charge a hefty Late Payment fee. Late payment fees vary by credit card program and number of times the cardholder has been late, but let's assume a $30 late payment fee.

* Get a million people per month to pay late, and you earn an additional $360 million dollars.

Penalty Interest Rate. Remember that 12% interest rate we talked about earlier? Most credit card programs allow for the bank to raise your interest rate substantially if you're ever late on a payment, to as high as 36%!

* Get 5% of your cardholders who carry a balance to make a late payment at some point, and incur a modest default rate of 24%, and you've generated another $900 million in revenue.

* These are hypothetical examples, meant to show the power of large numbers and not to give specific cardholder counts or revenue generated by any specific bank or credit card issuer.

The hypothetical revenue generated from the 5 income streams listed above totaled well over $11 Billion, without counting anything for transaction fees, and that was assuming a very small percentage of the US population. Account for the entire United States, and then expand to cover the rest of the world, and the revenue generated by credit card usage is astronomical!

So get to the point, you say, and I will. Credit card companies, and the banks who issue the cards, stand to make a lot of money. So, they will do just about anything to get new customers (and retain current customers), including offering rewards. Which brings me back to the opening paragraph - advertising for credit cards' rewards programs is everywhere you look. The real question is, "should you use a rewards card?"

Rewards Cards Benefits

Should you use a rewards card? The short answer is YES!

Free Money

Simply use your rewards card for your everyday purchases - at the grocery store, gas station, movie theater, restaurant, and everywhere else you spend money - heck, you can even pay your cell phone bill with your rewards card - and the credit card company will reward you with free stuff, or even with cash.

1-2% doesn't seem like very much, right? Spend $30 at the movies, and get a 45 cent reward - wow. But spend $30,000 over the course of the year and get $300 - $600 back. It's a nice windfall, considering you didn't change your spending habits at all - you would have spent every penny of that $30,000 with or without a card.

Why would the credit card company pay you if you're not paying interest? Because of the transaction fees discussed above - they're still making money every time you use the card. And even more than that, because some people who use their card will not pay it off every month, and then they stand to make lots and lots of money in interest and penalties.


Credit and debit cards both offer you the chance to dispute a charge if you see something fraudulent on your statement, but there's a big difference:

With a debit card, the money leaves your account first, and then you work with the bank to get it back over the course of a month or two, hopefully. If someone gets access to your debit card or account, they could empty your bank account before you even know it. You probably get your money back, but you probably also have a need for your own money over the next month or two, no?

With a credit card, you will see the charges on your statement before you send the card company your money, which means they will help you research the fraud without your own money at stake. And if the charges are deemed fraudulent, you won't be held responsible for interest &/or penalties incurred as a result of the charge(s).

Which rewards card should you use?

Each card has a different reward and fee schedule, and the better your credit is the better card you can get. Ultimately you'll want a program that maximizes hte rewards you can receive, depending on how much money you spend, and where you spend it.

Borrowers with excellent credit can probably find a card offering maximum rewards without an annual fee. Those with bad credit won't be able to get a rewards card until their credit improves a little bit. Those with average and good credit will want to weigh their options, and to change cards over time as their credit improves.

Rewards Cards Drawbacks

The biggest drawback to a rewards credit card is that, at its heart, it's still just a credit card, and if you're not ready or able to budget properly it can lead you down a debt-spiral trap that is difficult to get out of.

Remember all that money we talked about that the credit card companies make? If you feel great spending $500 because you're getting $7.50 in cash back, but then you can't or don't pay that $500 off when the statement comes due, you'll end up paying far more than that $7.50 in interest over the next several months - maybe upwards of $100 or more by the time you pay that balance off!

Do not let a potential reward entice you into paying interest, late fees, and penalties for several years to come.

In the End

Credit card companies are fighting for your business, and they're offering rewards as a major weapon in their arsenal as means to get you to sign up. Airline miles, free hotel stays, travel reimbursement, and cash back are their primary rewards, while the amount of the rewards and cost of the credit card will vary by program and based upon your credit score.

As much as I admire being "cash based", spending only what's available in your pocket or in your debit card's account, it seems silly to turn down free money. And it really is free, provided you don't change your spending habits.

But fall into the trap of spending more than your budget allows for, and you'll end up paying the credit card company far more than they're giving you in rewards.

Personally - the rewards we've earned over the last year will pay for the majority of our spring break trip this year. It's not a gazillion dollars (we don't spend a gazillion dollars either), but it's a nice bonus. We would have spent the same amount in 2014 either way, and we would be taking a trip over the boys' spring breaks either way, only this year it'll cost a lot less out of pocket. Cha-ching.

- Chris Butterworth

On Amazon - here are a couple-few related products you might find worthwhile: