How to Use Reward Credit Cards Effectively: Maximize Benefits and Minimize Pitfalls

Reward credit cards can be a powerful financial tool, offering cash back, travel points, and other perks for your everyday spending. However, they come with their own set of advantages and disadvantages. Understanding these can help you make informed decisions about how to use your credit cards effectively.

Warning: Most people fall into the trap of carrying credit card balances, which is how credit card companies can afford to offer such lucrative rewards. The interest and fees paid by those who carry balances significantly outweigh the cost of the rewards offered. If you find yourself often carrying a balance or struggling to pay off your credit card debt each month, this strategy is not for you. The interest charges would quickly outweigh any benefits you might earn from rewards.

How I Maximize My Credit Card Rewards and Minimize Pitfalls

I use a disciplined approach to ensure that I reap the benefits of my Fidelity 2% cash-back rewards without falling into the pitfalls:

1. Charitable Goals, Investments, Emergency Fund: When I'm paid, the first thing I do is allocate funds for charitable donations as part of my weekly budgeting. Then, I transfer money to my retirement and investing accounts. Finally, I transfer a set maintenance amount to my emergency fund, which is calculated by dividing my yearly average for unplanned expenses by 52 weeks. After these accounts have been paid, the remaining funds fall into my day-to-day budget.
2. Stick to a Budget: The remaining funds are allocated to a pre-planned budget. This helps me control my spending and ensures that I don’t overspend just to earn rewards.
3. Pre-Pay My Credit Card: I pre-pay my credit card with my budget for the week, treating it like a prepaid Visa debit card. At the end of the week, I reconcile the funds on the card. If there's a negative balance, I transfer less to the card the following week and invest the surplus. This keeps me from spending for the sake of earning rewards.
4. Use Rewards Wisely: I apply my cash-back rewards toward unplanned expenses before dipping into my emergency fund. This allows me to handle smaller unexpected costs without disrupting my emergency fund for every little hiccup. Most recently, I made some substantial repairs to my Honda using my accumulated cash-back rewards.

Example Scenario

Let’s say you have a $700 budget for the week spanning multiple spending categories. By pre-paying your credit card with this amount, you avoid the temptation to overspend the budgeted amount. At the end of the week, if you’ve only spent $620, you can invest the remaining $80 by transferring $80 less to the card next week.

The Pros of Credit Card Rewards

• Cash Back and Rewards Points: One of the primary benefits is earning cash back or points for every dollar spent. For instance, I use a 2% cash back credit card, which essentially means I'm getting a 2% discount on all my purchases. Over time, this can add up to a significant amount.
• Sign-Up Bonuses: Many credit cards offer attractive sign-up bonuses, often worth hundreds of dollars, if you meet a spending requirement within the first few months.
• Travel Perks: Some credit cards offer travel-related rewards such as free checked bags, priority boarding, or access to airport lounges, which can enhance your travel experience.
• Purchase Protections: Credit cards often provide purchase protections, such as extended warranties, price protection, and return protection, which can save you money and provide peace of mind.
• Convenience and Security: Credit cards are convenient to use and offer better security compared to carrying cash. They also provide fraud protection, meaning you are not liable for unauthorized charges.
• Liability Protection: When it comes to fraudulent charges, credit cards offer a significant advantage over debit cards. If your debit card information is stolen, recovering the stolen funds can be a lengthy and stressful process, with limited recourse. In contrast, with a credit card, it’s not your money that’s at risk. Any fraudulent charges can be reported and credited back to your account quickly, providing peace of mind and less financial disruption.

The Cons of Credit Card Rewards

• Overspending: Studies have shown that people tend to spend more when using credit cards compared to cash. A study published in the Journal of Consumer Research found that credit card payments increase the willingness to pay because the immediate pain of spending is reduced. If not managed carefully, this can lead to higher overall levels of spending and debt.
• High-Interest Rates: If you carry a balance on your credit card, the high interest rates can quickly negate any rewards earned. It's essential to pay off your balance in full each month to avoid interest charges.
• Annual Fees: Some rewards credit cards come with annual fees that can offset the value of the rewards, especially if you don’t spend enough to justify the fee.
• Complexity of Rewards Programs: Navigating the terms and conditions of rewards programs can be complex. Points may have expiration dates, or there may be restrictions on how and when you can redeem them.
• Impact on Credit Score: Mismanaging your credit card, such as missing payments or carrying high balances, can negatively impact your credit score.

Recap

Using a credit card responsibly can offer significant rewards and protections. By pre-paying my credit card and treating it like a debit card, I benefit from the rewards programs and liability protections of a credit card while maintaining strict control over my spending. This method allows me to end each billing cycle with a near-zero balance, ensuring that I never carry a balance and always maximize my rewards. This disciplined approach enables me to enjoy the best of both worlds: the convenience and benefits of a credit card without the risk of overspending or incurring debt.

Final Thoughts

It's important to note that the average American carries over $10,000 in credit card debt. With interest rates on the rise, it will become increasingly difficult for many to pay off these debts. Credit card interest rates can be as high as 30%, leaving no room for error. If you don't have the funds to buy something, don't buy it and don't use a credit card. If you carry credit card debt, please consider the full cost of a transaction and don't assume the reward is worth it. The interest payments would quickly outweigh any benefits you might earn. Always consider your financial situation and spending habits before deciding if a rewards credit card is the right choice for you.