Over the years, I had read quite a few personal finance stories of how some people were stuck in a mountain of credit card debts and the high interest rates on their credit cards had destroyed their financial health. In other stories, some people refused to use a credit card and resort to paying cash for everything. From these stories, some people got the misconception of using credit cards are bad for your financial health. This is only true if you don’t know how to use it. When you understand how credit card works and the perks that comes with it, it’ll do wonders for your financial health. Let me share with you how I get paid using my credit cards and build a great credit history.
Credit Card Basics
The most important thing to understand about credit card is that if you don’t pay the balance for the current bill in full, you’ll be charged with interest on all of your purchases on that bill from the day that you made the purchase. In addition, any subsequent purchases that you make after the first bill, you’ll be charged with interest unless you pay the first and second bill in full. If you withdraw cash from you credit card, the interest will automatically be charged from that day. In addition, if you have purchases on top of the cash advance, and don’t pay your bill in full, interest will be charged on both the cash advance and purchases. On the other hand, if you are disciplined and pay your bill in full every time, you get a free loan for three weeks – the grace period for you to pay your bills.
Interest rate on your credit card
For those that do carry a balance on their credit card, which I don’t ever recommend and vow to never do that again since my university days, the interest rate on the card matters. However, if you must carry personal debt, there are better options than credit cards and that will be discuss in another post. So if you always pay your balance in full for every bill (highly recommended), I don’t think the interest rate on the card matters at all.
Some cards have annual fees of $100 or more and provide the cardholder with a decent cash rewards on certain purchase categories like 4% on both gas and groceries and 1% on everything else. At the same time, there are other cards that have no annual fees and provide the cardholder with a cash rebate of 2% on both gas and groceries and 1% on everything else. So let’s do the math. Let’s say we have to choose between Card A with a $100 in annual fees and Card B has none. Which card is better when it comes to your annual spending?
Breakeven on annual credit card fees
To breakeven on Card A, let’s look at three scenarios: best, worst and average. The best case scenario for Card A is that all your purchases on the card are either gas or grocery. You earn 4% on all of your purchases. So ($100 = $2,500 * 4%) you’ll have to spend $2500 annually just to breakeven – you get no benefit. The worst case scenario for Card A is that all your purchases are not gas nor grocery. You only earn 1% on all of your purchases. So ($100 = $10,000 * 1%) you’ll have to spend $10,000 on the card annually just to breakeven. The average case scenario for Card A is that half of your purchases are either gas or grocery, and the other half is everything else. You earn an average of 2.5% (4% * 0.5 + 1% * 0.5) of the total purchase. So ($100 = $2,500 * 2.5%) you’ll have to spend $4,000 on the card annually just to breakeven. For Card B, the breakeven is $0 as there is no annual fee. Card B will earn $50 (= $2,500 * 2%), $100 (=$10,000 * 1%) and $60 (=$2,000 * 2% + $2,000 * 1%) respectively for the best, worst and average scenario.
When is Card A better than Card B?
Once again let’s look at the three previous scenarios. This time, we need to find the same spending amount where each card would earn the same cash back rewards. So the equations are:
1) Best case scenario: (Purchases on Card A) * 4% – 100 = (Purchases on Card B) * 2%
2) Worst case scenario: (Purchases on Card A) * 1% – 100 = (Purchases on Card B) * 1%
3) Average case scenario: 0.5 * (Purchases on Card A) * 4% + 0.5 * (Purchases on Card A) * 1% – 100 = 0.5*(Purchases on Card B) * 2% + 0.5 * (Purchases on Card B) * 1%
* Note: Purchases on Card A = Purchases on Card B
For the best case scenario, both cards will earn $100 in rewards if the cardholder spends $5,000 on the credit card annually, which means if you spend more than $5000 on gas and grocery, it’s better to go with Card A. Otherwise, stick with the no fee Card B. For the worst case scenario, Card B will always be better than card A as both cards earns the same cash back reward of 1% and Card B has the advantage of no annual fees. For the average scenario if you spend more than $10,000 on your credit cards, it’s more rewarding to go with the annual fee Card A as you have the potential to earn more rewards.
Credit history benefit
When it comes to credit card rewards, most people rarely thought about the credit history benefit and how it can help the card users in the long run. For starter, when you have any sort of recurring bills in your name like phone, internet, utilities, subscriptions and even credit card bills, all the payment history that you made (or missed) were be reported to the credit bureau companies like Equifax and TransUnion. If you always pay your bills on time, it’ll help to enhance your personal credit score and your credit worthiness reputation to any future potential lenders that pull your credit reports from these credit bureaus. For example, some time in the future, you may be thinking of applying for either a car loan or mortgage or personal line of credit, the lender will be pulling your credit report from the credit bureaus to assess your credit history. Having no credit or bad credit history can cost you thousands of dollars because you will not get the best interest rate on your loan due to your credit history or credit score.
My two cents
With so many credit cards that offer users a boat load of rewards, I don’t think that it’s necessary for the average credit card user to pay an annual fee to maximize the benefit of the credit card rewards, unless you use your credit card for the majority of your purchases and your annual expense is greater than $10,000. The most important thing to remember is to always pay on time and in full. Otherwise, a substantial portion of your rewards will be given back to the credit card company if you missed just one payment. For the people that resisted using credit cards, you don’t have to use the card for all of your purchases to build your credit history. All you have to do is us it once or twice a month and always pay on time. To reap the full benefit of any financial tool, the user must understand the basic requirements, steer away from the drawbacks and gravitate towards the benefits.