Making money out of spending money

I recently switched credit cards from one bank to another to take advantage of better loyalty scheme benefits.  Wading through the myriad of options to choose a new credit card is no easy task – the right choice of card depends not only on your income level, but also on your personal spending and travel patterns.   However, if you choose and use your credit card wisely, you will save money and enjoy the benefits of freeriding on a payment mechanism designed to profit from the ill-disciplined.

To understand just how you can benefit from using a credit card as your primary payments method, let’s consider the case of a couple, with two incomes, no kids, and who travel overseas once per year.  For this couple, a reward scheme-aligned gold or platinum credit card (hereafter premium credit card) is a natural choice.  Such a card, not only offers the benefits of reward accrual, but typically also offers complementary travel insurance.  The remainder of this article considers the costs and benefits of this choice.

The direct cost for a couple wanting to have a premium credit card is a $100-$150 annual account fee, plus $20-$30 for an additional card.  Of course, additional interest expenses may also accrue should you lack payments discipline, but let’s leave those aside for now and focus on the benefits of using a credit card.

The benefits from holding a premium credit card fall into two camps: Those benefits that stem from loyalty scheme and travel insurance freebies, versus those benefits derived from taking advantage of the interest-free period before your credit card bill is due.

The exact scope of loyalty scheme benefits depend on your chosen bank and whether your credit card is gold or platinum.  As a guide though, expect to at least earn an Airpoints dollar (or a similar value of cash equivalent rewards points) for every $100 spent on your credit card.  To put this in perspective, a couple who typically spends $30,000 per year ($2,500 monthly) on goods and services that accept credit card payment would earn $300+ worth of loyalty scheme bonuses.  Subtracting away annual account fees, shows that this couple is at least $120 better off each year than if they had chosen to pay in cash.

The other key freebie offered with premium credit cards is complementary travel insurance (so long as you pay for your flights etc with your card).  A quick look at the underwriters and policy wordings suggests that these complementary policies are roughly equivalent to the types of basic travel insurance policies one would purchase online.  As a result, assuming the couple takes a two week overseas holiday each year, they could save themselves as much as $300 if they were to jet to the US.  Taking the value of this complementary travel insurance, in conjunction with the reward points outlined above, shows that our couple would benefit by around $420 per year in net terms by using their credit card.

All of these discussions so far have simply looked at the costs and benefits of spending with a credit card.  However, we have not yet touched on the fact that using a credit card is a great way of smoothing cash flows over a month.  Some people fear credit card bills, but these bills shouldn’t be a burden so long as you don’t spend more in a given month than you expect to have in available cash when your bill is due.  Following this strategy ensures that you can pay your bill on time and avoid interest charges kicking in.

The great thing is that by allowing you to delay payments by an average of one month, there is also another measurable financial benefit from this aspect of credit card use.  This benefit occurs because you can invest the money you would have used on a particular transaction and earn interest over the month before your credit card bill is due.  Based on our earlier assumption that the couple spends $30,000pa on their credit card, the value of delaying payments by an average of one month is $73.50 over the course of a year (assuming a 4.2%pa return off a Rabobank PremiumSaver account and a 30% marginal tax rate).

Adding this interest income, to the travel insurance savings and reward points discussed above, shows that our couple would be around $500 per year better off using their credit card than if they used cash to pay for the same day-to-day consumption of goods and services.  These benefits sound too good to be true, but they really aren’t, so long as you maintain the same spending discipline as our model couple.

But if you aren’t so disciplined (and banks really hope that you are not), then your credit card can quickly change from being a wealth-enhancing device to a real drag on your pocket.  This drag stems from the fact that any outstanding credit card debt after your credit card bill’s due date begins accruing interest at a rate of around 20%pa.  Imagine a scenario where our couple’s spending got a month of so ahead of their cash flow, such that they typically averaged $2,500 of outstanding interest-bearing credit card debt.  In this situation, the benefits our couple gained from travel insurance and reward points would quickly be negated by the $500 per year of interest charges they now faced.  One can only imagine the drain on their pocket if our couple got three or four months behind in repayments.

And this situation of ill-discipline with credit cards is a trap that many people fall into.  A quick glance at data from the Reserve Bank shows that interest-bearing credit card advances averaged 67% of total credit balances over the past year.  It is understandable that sometimes people need access to credit, but a cheaper option would be extending your mortgage or getting a personal loan rather than habitually relying on your credit card as a financing mechanism.

But why should I care? So long as banks can continue to profit from these hordes of people with interest-bearing credit card balances, then the status quo remains.  As a result, people like me can keep freeriding and enjoying the benefits of sensible credit card use!

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