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By Alice Lesch Kelly
The offers sound enticing: Get hundreds of dollars in cash for opening a credit card account. Earn money back on all of your purchases. Rack up points you can use for free airfare, free hotel nights, free restaurant meals. Receive discounts on everything you buy at a particular retailer.
With offers like this, you’d be crazy not to sign up for a wallet full of rewards cards, right?
Maybe not. Although rewards-based credit cards can benefit some consumers, they’re not for everyone. “If you’re not careful, you can end up paying far more in fees and interest than you receive in rewards,” says Michael Ferreer, chief member officer at Direct Federal Credit Union, a community chartered credit union based in Needham, Mass.
“Miles, cash back, travel, discounts, and other rewards are sexy incentives that appeal to our desire for instant gratification,” says Lauren Skinner Beitelspacher, Ph.D., associate professor and chair of the Marketing Division at Babson College in Wellesley, Mass. “Rewards are an incentive that appeal more to our hedonic side than our utilitarian side. Free nights in a hotel sound like more fun than a low interest rate.”
Unfortunately, credit card issuers know that offering consumers exciting rewards is an effective way to distract them from high interest rates and hefty annual fees. “Issuers bet that consumers will be so focused on getting a free flight to their desired vacation destination that they won’t calculate what that ‘free’ flight will cost them in interest and fees,” says Ferreer.
“Consumers don’t always do a good job of thinking about long-term consequences. They sign up for these cards thinking they’ll take the bonus or the rewards and pay off their balance every month and come out ahead,” Beitelspacher says. “But if they don’t, they pay for it. Nobody opens up a credit card assuming they’re going to accrue a lot of debt.”
Programs with history
Credit card rewards programs have existed since the 1980s, when credit card issuers joined forces with airlines to offer consumers airline rewards, or miles, when they used certain credit cards. These were followed by cash-back programs that refunded consumers a percentage of their spending each year, as well as an ever-growing array of other rewards programs.
Today, consumers can choose from many rewards programs with a range of benefits. Meanwhile, online experts offer guidance on how to optimize rewards in what has become, for many people, something of a game.
But it’s a game with potentially serious risks. If you don’t play the game right, it can cost you. For example, if you don’t pay your balance every month, you might end up paying sky-high interest rates.
“You may intend to pay your balance, but what happens is you’re in the company’s system and they keep offering other rewards and other incentives,” Beitelspacher says. “The more you spend, the greater the rewards. But the bill will come. It always does.” If you can’t pay your balance, interest rates as high as 27% or higher can kick in.
Doing the math
What will high interest rates cost you? Quite a bit, says AnnaMarie Mock, a certified financial planner at Upswing Advisor, an independent financial services firm in Wayne, N.J., that helps young professionals with financial planning.
“The average credit card interest rate is around 16% to 18%, while reward benefits can be limited to usually 1% to 5% of purchases,” Mock says. “If you don’t pay your balance in full every month, any rewards gained from the credit card are completely eroded by the high cost to carry that debt.”
For example, if you have a revolving balance of $1,000 with an interest rate of 17% and you don’t pay it down over the course of a year, you will owe $1,184. Although you will pay $184 in interest, your rewards are likely to be worth only $10 to $50, Mock says.
While many aspire to pay off their credit card in full each month, a Federal Reserve Survey found that in 2019, about 45% of credit card holders carry a balance from month to month.
“For people who don’t pay their balance every month, the interest rate will be very important, and they should be focused on that,” says Katherine A. Kiel, Ph.D., a professor of economics at College of the Holy Cross in Worcester.
What’s more, although some rewards cards have no annual fee, others charge as much as $695 or more per year. Paying that $695 may be worthwhile if you never carry a balance and know you will receive and use at least $695 in rewards, but if you don’t, you could lose out.
“They should be comparing the annual fee against the rewards to verify that they’ll get more in rewards than the annual fee,” Kiel says. “People should be checking how the rewards are accumulated, how they can be spent, and if they expire. They should also consider how easy or difficult it will be to redeem the rewards.”
Rewards cards may offer bonuses for balance transfers, but those bonuses likely will not make up for high interest rates on transfers. “It is far better for someone with a high balance to seek out the lowest interest rate card they can find,” says James D. Kinney, owner of Financial Pathway Advisors, an independent financial planning firm in Flanders, N.J. “The interest savings on your accumulated debt is likely to be worth far more than the value of the rewards and bonuses you receive.”
A smarter alternative
Certainly, some consumers can make the numbers add up for rewards credit cards. But for many people, choosing a low-interest credit card with no annual fee makes better financial sense than a flashy card that offers points or rewards.
For example, Direct Federal Credit Union (Direct.com) offers a straightforward, low-rate credit card option that includes a balance transfer offer of 0.00% annual percentage rate (APR) interest for six months and then a low rate of 4.99% APR until the balance is paid off. There are no balance transfer fees or annual fees.
For purchases, Direct.com’s interest rates start at just 8.99% APR, based on your credit score. Plus, it offers 1% cash back on all purchases.
As with all of your financial decisions, the best way to select a credit card is to look closely at interest rates, annual fees, and transfer fees, as well as any cash back or reward you may receive. Don’t let freebies and prizes distract you from the bottom line: How much the card will cost you or could cost you if your financial situation changes.
“It really benefits people to take some time when they pick a credit card to work carefully through the numbers,” Kiel says.