Don't be fooled. Your interests and the interests of your credit card company are not aligned. And I know: I used to run a profitable credit card business.
For the lender, an ideal customer is someone who maxes out their card and only pays the minimum due, one week late, every month. Consider this scenario: If a person borrows up to a credit limit of $10,000, has a 21 percent interest rate and makes only their minimum payments, that customer would pay more than $2,000 in interest alone over the next 12 months. If he paid late every month, he'd be out another $420 (in 12 $35 fees).
To help you avoid becoming an ideal customer, I'll explain the three ways credit cards make money, then unveil the typical tricks used by the banks, and give you tips so that you can make credit cards work for you.
Every time you use your card, the merchant pays an interchange fee to your credit card company. Interchange rates average 2 percent. Last year, Americans spent $2.2 trillion on credit cards issued by the top 15 banks. If banks kept the 2 percent interchange, that would be $45 billion in their pockets, and not in yours. Your goal: Get it all back.
Whether you pay with a credit card, debit card or cash, your price is the same. But, if you use the right credit card, you can get cash back or airline miles. Think of it as a rebate, because it's your own money. But beware of advertised deals that look too good to be true: Banks only get 2 percent, so promising you more should raise suspicion. Typical tricks include:
- Advertising a really high cash back rate. Discover (DFS) and Chase (JPM) do this, by advertising 5 percent cash back. But you only get 5 percent on certain categories that rotate every quarter and are capped. You have to opt in every quarter. All other categories pay only 1 percent.
- Advertising a higher rate on fixed categories. Bank of America (BAC) offers 3 percent on gas, 2 percent on groceries and 1 percent on everything else. But the 3 percent and 2 percent are capped to $1,500 in spending per quarter.
- Giving a massive introductory bonus. Wells Fargo (WFC) offers a credit card where you can earn 5 percent on gas, groceries and drugstores for the first six months. But then the cash-back rate drops to 1 percent.
- Creating a rewards currency, but hiding its real value. When a bank creates its own currency (like Regions Bank Relationship Rewards (RF)), they tend to tell you how many points you will earn, but they're not so eager to tell you what the points are worth. Usually, it's less than 1 percent of the money you spent to get them.
Personally, I look for a card that offers a flat, no-gimmick, high cash back rate. Two of my favorites:
- The Fidelity Investment Rewards American Express Card (AXP) pays 2 percent cash back on every transaction, with no cap. The only catch: you must have a Fidelity account, where your cash will be deposited. Why does Fidelity do this? It is not in the credit card business. Its goal is to grow your balance at Fidelity, and the cash back does just that.
- Capital One Quicksilver (COF) offers 1.5 percent cash back on all of your spending, without caps.
If you are a frequent flier, earning miles may make sense. With an airline card, the bank uses the interchange to buy miles from the airline, rather than giving you cash.
Frequent flier programs can be confusing, and you need a lot of miles to get free flights. To see how much free travel you can earn, a tool at MileCards asks you how much you spend each month and where you want to travel. The tool shows how many miles you earn, and the value of those miles. You can compare that to the cash back you would earn, and make an informed decision.
Make sure you pay the balance in full and on time every month. If the bank gives you 2 percent, it will try to make money elsewhere.
Charging interest on debt is the big money maker for credit card companies. Their goal is simple: get you to borrow as much as possible at an interest rate that is as high as possible.
To get you to borrow, credit card companies give big credit limits. Bankers refer to the maximum amount of debt you can handle as the tipping point, and they have statistical models to get you as close to the tipping point as possible.
Interest rates are high. I often see 15 percent quoted as the average rate. But banks charge different interest rates depending upon the customer profile. If you do not pay your balance in full every month, you are considered riskier. Riskier customers get higher rates. We did a national survey, and 75 percent of people with credit card debt paid higher than 15 percent.
Your interest rate can still be increased by your credit card company if:
- You engage in risky behavior, like missing a payment (even by a day) or going over your credit limit. Banks can increase your interest rate on all future transactions. Thanks to the CARD Act, they cannot increase the rate on your existing balance.
- You become 60 days late. Once that happens, you lose your CARD Act protections, and they can increase the interest rate on your existing balance as well.
You should have a credit card for spending. On this credit card, you earn cash back and pay the balance in full every month. You will never pay any interest at all. If you don't have the self-discipline to only spend only what you can afford, don't be afraid to use cash.
For your debt, you should find the lowest interest rate credit card available, transfer the balance to that card and then hide that card in the freezer. In my last article, I showed how I saved a woman over $3,000 in 30 minutes.
Final warning: cash advances are the most expensive form of credit card borrowing. There is usually an up-front fee, and interest is charged immediately.
There are two types of fees: punishment and transaction.
Punishment fees include:
- Late fees. Avoid by signing up for a direct debit. Otherwise, be aware of the cutoff times for payments, which are often as early as 5 p.m.
- Over-the-credit-limit. Banks need your permission to charge this fee. Don't give it.
- Returned payment or returned check. If you write a check that bounces, then you could be hit with both a returned payment and late fee.
- Cash advance fees. They average a steep 3 percent.
- Foreign transaction fees. The fee averages 3 percent when you use your credit card abroad. Many cards now charge no foreign transaction fees, including all cards offered by Capital One. (With Capital One Quicksilver, you avoid the fee and earn cash back).
More Money in Your Pocket
Credit cards are complex. But these four tips will put more money in your pocket:
- Have a spending card. Earn at least 1.5 percent, and pay off the balance in full, every month.
- If you have debt, find the lowest interest rate credit card (usually with a balance transfer). Move your debt to the lowest rate and put the card in the freezer.
- Make sure you always pay on time. Even paying a day late can be obscenely expensive (late fees and higher interest rates).
- If you travel overseas, make sure you take a card with no foreign transaction fee.