By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business
and Dr. Karin Ford-Torres
Faculty Member, Wallace E. Boston School of Business
This is the fifth article in an ongoing series on sound tips for financial security and prosperity. Nothing in these articles is intended as formal legal or financial advice. Readers should consult an attorney or licensed financial advisor before making any financial decisions.
In the previous installment of the Smart Finance 101 series, we covered the concept of interest — both paid and earned — and why understanding it is so important to competent financial management. Now, we’re going to look at credit cards — when, how and why to use them.
Credit cards are simultaneously one of an individual’s greatest financial tools and also one of the biggest financial risks. As with so many things, the key lies in how credit cards are used.
Many cautionary financial advisors recommend that inexperienced consumers and/or those who cannot make responsible decisions with their finances should stay away from credit cards altogether. This is probably good advice under these circumstances. So if you’re such a person, it might be a good idea to cut up your credit cards right now and switch to cash-only purchases until you’re in a better position to manage debt and investments.
However, in this article we are going to argue that the inverse is true as well. That is to say, if you’re someone who is fairly knowledgeable and responsible with your finances, we would recommend buying everything you possibly can with a credit card.
By Using Credit Cards for Purchases, You Can Actually Come Out Ahead
Why, you ask? It’s a simple matter of return on investment (ROI). By using credit cards for purchases, you can actually come out ahead of where you would have been if you had paid cash. But of course, doing so requires strict self-regulation and unwavering discipline.
Credit cards generally come with high interest rates. The average interest rate is 14 to 18%. That’s high enough that there’s virtually no chance of earning a superior return by carrying debt and investing the money elsewhere — a strategy we discussed in the last parts of this series.
So the best policy with credit cards — really the only sensible policy — is to pay off your credit card debt in full every month. If you pay your entire statement balance each month, you will pay no interest because interest is only applied to revolving debt that is carried over from one month to the next.
By Paying Your Bill on Time Each Month, You Build a Positive, Reliable Credit History
Then why use a credit card at all if you’re never going to carry debt on it? There are two important reasons. And the first is your credit history and credit score. By using a credit card, drawing against it and paying your bill on time each month, you build a positive, reliable credit history that raises your credit score.
A good rule of thumb is to use only about 30% of your available credit each month, but not more. This is because even if you pay all of your bills on time, the balances are reported to credit bureaus each month. And if you have too high a balance relative to your credit limit, it can look like you are over-leveraged (i.e. “maxed out” on spending), which can negatively impact your credit score.
A Higher Credit Score Gives You Access to Better Lending Options and Potential Rewards
Why does your credit score matter? A higher credit score gives you access to lending options that you might not have otherwise, including lower interest rates and more favorable terms for mortgages and other long-term debt vehicles.
The other important reason is rewards. And this is where you can really make the immediate return on investment of using a credit card. Many credit cards today offer rewards programs — kickbacks that reward consumers for the purchases they make. There are even rewards cards available for individuals with negative or non-existent credit history. And if you take full advantage of these rewards, they can really add up.
But not all rewards programs are created equal. And consumers should be careful about which rewards models they buy into, as actual returns with some schemes can be really misleading. For example, a lot of credit cards offer “points” that can be redeemed to make purchases elsewhere. But the critical factor with these programs is the conversion ratio.
A bank might try to sell you on signing up for a new credit card by offering, say, “50 million bonus points” for new customers. Sounds awesome, right? Sure, except for the fact that a “point” is a fictitious rewards currency created by the bank out of thin air. And until you know what a “point” is worth in actual dollars, you can’t really make heads or tails of the value being offered.
It’s Rare to Find a Simple Chart or Table that Explains What Credit Card ‘Points’ Are Worth
But banks are notoriously dodgy on this point; it’s rare to find a simple chart or table that explains what a credit card’s “points” are worth in basic dollars and cents. Instead, banks often camouflage value through purchases or conversions to cash or cash equivalents made directly through points, meaning that consumers have to do some tricky reverse math if they really want to understand what they’re getting.
For example, suppose your bank talks you into those 50 million bonus points to sign up for its new credit card. Then you go to the bank’s rewards redemption website and find that, say, a toaster oven costs 100 million rewards points. Based on this figure, you can recognize that your 50 million bonus points are enough to buy you half of that toaster.
Now, if you can find that same make and model available elsewhere for sale with regular U.S. currency, you can use the selling price to work out what you’re actually getting in “points.” For instance, if you go to Amazon.com and discover that the same toaster oven can be bought for $20, then you now know your 50 million points are actually only worth about 10 bucks. It sounded a lot better in points, didn’t it?
In the next part of this series, we’ll look at how banks do this in an even sneakier way with credit cards that offer reward “miles.” We’ll also discuss better options for credit card rewards programs. And finally, we’ll close with some additional tips for responsible and strategic credit card use.
The university offers academic programs in accounting and finance, which cover important financial discussions in depth. Readers who are considering expanding their knowledge and credentials in this field are encouraged to visit our program pages for more information.
About the Author
Dr. Gary Deel is a Faculty Director with the Wallace E. Boston School of Business at American Public University. He holds a J.D. in Law and a Ph.D. in Hospitality/Business Management. Gary teaches human resources and employment law classes for American Public University, the University of Central Florida, Colorado State University and others.
Dr. Karin Ford-Torres is an Associate Professor with the Wallace E. Boston School of Business at American Public University. She holds a Ph.D. in Business Administration with a concentration in Advanced Accounting and Financial Management. Karin teaches accounting and finance courses for American Public University, Purdue University Global and Colorado State University-Global. She has 24 years of prior banking experience with Bank of America.