Is it worth paying interest to earn credit-card rewards?
Most credit cards are give and take. They can save hundreds of dollars through rewards, miles and points, while at the same time charging you tons of interest. It all comes down to how you use them. Many readers frequently ask whether one can earn enough reward points to nullify the negative effects of interest charges. While technically the answer is "yes", it's not something that should be done. In most cases, you will end up losing money. Worse yet, you can open yourself up to a number of risks that can jeopardize your finances.
Credit card interest is expressed as an annual percentage rate while rewards come in many different shapes and sizes – miles, points and cash back. This makes a direct comparison counterintuitive. Therefore, it helps to reduce all the miles and points you earn down to a rewards rate. That is the return, in rewards, a cardholder gets for every dollar spent, expressed as a percentage. For example, a decent travel credit card can come with a 2.5% rewards rate on dining out and travel. This means if you spend $1,000 in these categories, you will get back $25 worth of points. Since the rewards rate represents a gain, while interest a loss, we can then see how the two compare on the same scale.
For simplicity’s sake, let’s assume you get 1.5% cash back on all your purchases. This is a solid rewards rate you can expect to get if you have average to good credit. We will also assume the credit card comes with a 20.90% APR, which is average among cash back credit cards. For our calculations, we assumed the cardholder was making $2,000 in purchases each month, and paying back 50% of the remaining balance. After just 6 months, the sample cardholder would begin losing money.
Bonuses Are The Exception to The Rule
When you earn a credit card bonus, you have a huge surge in value for your first few months of membership. This usually tips things in favor of credit card rewards over interest. Therefore, if you’re able to nab a $700 bonus, it’s unlikely interest will entirely eat away at it within the first year.
However, it’s a bad idea to let this short-term boost cloud your judgment. In the end, interest charges can be a huge threat to your financial stability. Financing small purchases is a terrible habit to get into. It’s bad even if you manage to come out with a net gain in the short term. This is because financing purchases forces you to speculate about your future ability to pay it back, leaving little room for emergency expenses. Every time you make a purchase which you don’t plan to pay off at the end of the month, you are guessing that you will eventually have the funds to pay it off completely plus interest. However, when unforeseen expenses arise, your plan may be offset by a few months or even years. The longer you drag out re-paying a debt, the more you’ll have to deal with that pesky APR.
Instead of trying to marry interest and rewards, pick just one. Focus on getting a low interest or zero percent APR credit card if you know you cannot afford to pay for all your day-to-day expenses out of pocket. You should open a rewards credit card account only once your finances are in order, and you're ready to fully pay off your bill each month. This is the best way to optimize the way you pick and use a credit card.
This story originally appeared on ValuePenguin.
