You heard it before. "Don't prioritize credit card rewards if you're going to pay interest charges." However, this old adage may be increasingly difficult to believe. Some high-end credit cards today come with rewards as high as 2.5% or 5% returns on purchases. When you factor in bonuses that can, in some cases, be worth hundreds of dollars, can all these factors outpace interest charges? The short answer is: no. Even though credit card rewards are at an all-time-high, interest charges, in most cases, will edge out ahead of them.
It's natural to be skeptical about such claims, so it may help to see the principle in action. Let's look at a concrete example. Take an individual with a cash back credit card earning a 1.5% return on all their purchases. This is cash back rate offered on everyday credit cards. The average APR on a cash back rewards credit cards is around 20.9%. According to the Bank of America Consumer Spending Snapshot, the overall spend per active account in July was $1,098.37. Let's assume the example consumer spends that much, and pays off 50% of their remaining balance every month. Over two years, the consumer in this scenario would end up paying $447 in interest, and earn just $395 in cash back - a net loss.
Our model consumer would need to pay off over 86% of their monthly balance to just break even. Anything less than that and they will always lose money, despite their rewards. Keep in mind that arriving at the above results was moderately difficult, and that's with a simple rewards rate. Most credit cards you'll come across have different rates for different categories of spending. In such cases, it's not so easy to figure out how much you have to pay each month to come out ahead.
The Hidden Cost of APR
The scenario described above may cause some to think "Great! I can put off 14% of my purchases, and still not lose money!" This, however, doesn't consider the true danger of carrying a balance. There are plenty of scenarios one could come up with where paying interest for a month or two doesn't seem bad. But what happens if you an emergency expense comes up? Life is full of little costly surprises. A trip to the emergency room or your car breaking down may put a strain on your finances - something you didn't budget for. All of a sudden, you may be unable to pay 86% of your credit card balance. The credit card interest begins eating away into your finances. It compounds and becomes more and more difficult to deal with. Depending on the severity of your emergency expense, this can be a minor or major headache.
Bonuses Can Temporarily Offset The Cost of Interest
Credit card bonuses vary in value from $150 to $1,500. When you earn one, it heavily skews the net returns in your favor. However, over time, the impact of bonuses diminishes. After the first cardmember year is up, the initial boost in value typically diminishes and you begin losing money by carrying a balance.
The hidden costs we described above are also just as dangerous, even if you earn a bonus. Don't allow the short-term value boost to make you blind to the dangers of emergency expenses.
The biggest lesson to take away from this is this: don't put charges onto your credit card unless you can pay them off in full at the end of the month. If your financial situation doesn't allow for this, focus on a card's APR. Look for low interest or zero percent credit cards, instead of reward ones.