Rates vs. Rewards: Weigh Your Credit Card Options Carefully

When it comes to credit cards, there are two types of people: those who carry a balance each month and those who don’t.

One of the common themes that I hear in conversation with clients is that the people who carry balances should have a card with the lowest interest rate possible, while people who pay their balances in full are best served by rewards-based credit cards. This holds true, for the most part, but this sort of “either-or” thinking might cost you in the long run.

In making the best choice, you need to consider five things:

• your average monthly spending
• the value of all rewards over time
• the interest rate difference between cards
• the average balance you’ll be carrying each month
• the annual fee (if any)

For example, let’s look at someone who spends $2,000 a month and carries a $3,000 average balance. A low-interest card might offer a 15 percent Annual Percentage Rate (APR), and a rewards card that offers 1 percent cash back might have an APR of 18 percent. And let’s assume neither card carries an annual fee. At first glance, it might appear that the lower-interest card is the better option. But let’s take a closer look at the numbers.

• The annual interest expense for carrying the $3,000 monthly balance on the low-interest card at 15 percent is $450.
• Meanwhile, the annual interest expense on the rewards card is $540, for a difference of $90.
• But, with a total spend of $24,000 a year, cash back from the rewards card would come to $240.
• So at year’s end, you would be ahead by $150 with the higher interest rewards card.

Opting for the lower rate card just because this person carries a monthly balance would “cost” him a net of $150 per year. Even an annual fee of $149 (as outrageous as that sounds) on the rewards card would still make it a slightly better deal than the low-interest option.

If we lower the monthly spending to $500 with all other things being equal, then yes, the lower interest rate card is the better choice. Annual rewards would only total $60 ($500 x 12 = $6,000 x 1 percent = $60), while the interest rate difference would remain at $90. It would be unwise to spend $90 in additional interest to collect just $60 in rewards.

Keep in mind that rewards come in all shapes and sizes, and you may have to do some more mathematical gymnastics to figure out their overall value. For example, some cards offer bigger rewards for different purchase categories like 2 percent for gas, 3 percent for groceries and 1 percent for everything else. Those category-specific bonuses may increase the effective reward to somewhere around 1.25 percent - 1.5 percent for the average cardholder or household.

As you can see from these examples, several factors come into play here, especially the amount of money you spend each month. When doing your analysis, make sure you’re including all spending so you don’t leave any money on the table. This includes what you spend using a debit card and bills you pay by check or by automatic draft.

Migrating these expenses to a rewards credit card can make a big difference. Since the money won’t be coming out of your checking account directly, make a habit to pay the credit card frequently (maybe once a week), and always have a plan and the means to pay it off. That way you’ll prevent carrying a balance, or keep the balance you do carry in check so any interest you’re charged doesn’t “outrun” your rewards.

A word of caution about the bills you pay with checks or by automatic draft. Before using your credit card to make those payments, make sure the company isn’t tacking on a surcharge to accept the credit card payment. Some companies charge an additional 2 percent to 5 percent to process credit or debit cards. If the surcharge is larger than the card reward, it’s best to continue to pay by check or automatic draft.

Run the numbers based on your own spending and balances. You may find treasure in a place you never thought to look.

Greg Davis is an office leader for Pinnacle Financial Partners in Goose Creek, SC. He can be reached by phone at 843-553-0021 and by email at Greg.Davis@pnfp.com.