I realized something today. I don’t know the interest rate on either of my two credit cards. I use an American Express card for most purchases, and I have a Visa for the places that do not accept Amex.
The topic came up because I was talking about personal finance with a coworker at lunch today. We were discussing how people can get in over their heads with credit cards, and how that can force people into bankruptcy. She told me that she didn’t understand that, because she had a low rate on her credit card. “It’s only 2.9%, but I don’t even pay that because I pay off my balance every month.”
I also pay off my balances in full every month. And because I have been doing that for as long as I can remember, the interest rate on the card is irrelevant to me. What is relevant to me is that I get air line miles from my credit card.
The important thing to remember about the credit card industry is that they make money from two income sources. First, they make money from the interest charges paid by cardholders. But a more reliable source of income is the fees they charge merchants to process the transaction. These charges can be upwards of 2% of the cost of the item being charged.
So let’s say you’re American Express. Most Amex users are businesses who pay their bills in full every month. When I charge something using my card, Amex pays the merchant 98% of the purchase price right away. I pay Amex 100% back, on average a month after I buy the item. If you are getting 2% a month for the use of your money, that becomes a 24% rate of return on an annual basis.
Since American Express is raising capital in the public markets, their cost of capital is (just a guess) around 6% a year. With borrowing money at 6%, and getting a return of 24%, the differential is an 18% return. If you are making that kind of return, you can offer considerable rewards as part of your marketing plan.
But not considerable cash back. If Amex offered 1% cash back, that would lower the differential to 6% a year, which doesn’t leave a lot left over after operating and marketing costs are taken out. So the card companies that offer that kind of cash back are depending on the first source of income: interest charges paid by cardholders.
So far, I know of only one credit card company that would let me check out the tradeoffs involved in getting rewards such as cash back. So I checked out the Capital One Card Lab, which you can find here. With excellent credit, a menu of options pops up. Choosing one option, like 1% cash back, removes other options, like some of the interest rate choices.
Ohhhh, a game! Let’s play!
After playing a few rounds, I settled in on 2% cash back on gas & groceries, with no annual fee. If I agreed to a 20% APR, they’ll set the APR at zero for the first year. So I could use their money for a year, while my cash was earning interest in a money market account. All I have to do is remember to pay it off in full at the end of the year, and every month thereafter, and I never have to pay that 20%.
A 2% reduction in gas and grocery costs, paid for by someone else? This is a game I just might play.
2 comments:
When a person is searching for a new credit card or gas cards, they need to be aware of things such as if the APR is variable or fixed, is there a rewards/point program and if so do they points expire, is there annual fees associated, is there balance transfer fees and is there any cashback rewards programs for the card. A little homework can save a person tons of money in the long run.
Creditkards has completley missed the point of my post, which is that if you pay off your credit cards every month, you don't need to be concerned about the APR. You are free to taylor the rewards to what works for you.
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