Recovery from Financial Disaster

Ever wonder how you’d handle a complete reversal of your finances? I have a friend who had a lifestyle most people would envy and lost everything, including her marriage. I didn’t meet her until after her recovery from her financial disaster. She is one of the most resilient, generous people I know and was kind enough to let me interview her about the changes in her life, the financial lessons she learned and her advice to you on how to avoid finding yourself in a similar situation.

The High Life

“My life was very plentiful with many material objects.

  • 6,000+ square foot custom designed home – 6 bedrooms, 5 bathrooms and two full kitchens
  • Photography and recording studios
  • In ground swimming pool
  • Custom designed furniture
  • Six cars
  • Trips
  • Private education for both kids
  • Entertainment

I never priced groceries, just grab and dash.  We belonged to a private country club as well.  We also had an investment property that we rented to a family member.”

Tell Me about Your Finances

“I did not think of my financial future.  I was in my mid to late 40s and I thought the gravy train would never stop.  We had many investments, 401(k) and IRA retirement accounts for us as well as the children.  My husband was a very successful stock broker, financial planner and money management specialist. We had a dual income, and mine paid for the cream on the top.”

What Happened?

“The stock market along with the real estate market became very soft in 2007.  When I began to notice that these change were imminent, I suggested that we liquidate assets into a strong cash position.  My husband dismissed my thoughts on this topic because I had never been persistent in being a co-manager of our funds.  The economy was showing its ugly powerful head and so was our 40-year marriage.

Things went from bad to worse.  We lost our home. Instead of getting money from the buyer when we sold our house, we had to come to closing with a six-figure check to pay off the mortgage balance (because we owed more than we got for the house). Otherwise, we would have had to negotiate a short sale with the holders of the loan on the house to try to get them to accept only the amount for which we sold it, but chose to close in a traditional manner due to a prideful attitude that made no sense at all.

We divorced.  The money, the investments and the lifestyle were gone.  I was 59 years old. Our children were grown and gone.  Thank God they had their educations!”

What Did You Do?

“I moved into a house with five other people to secure a reasonable rent of $600 a month.  I rolled up my sleeves and decided to re-invent myself as a strong salesperson with a steady stream of income.  As part of creating a fiscally responsible lifestyle, I consolidated my debt and made a conscious effort to understand my taxes and my expenses.  These changes allowed me to pay off the tax liability for which I was half responsible after the divorce.”

What is Your Life like Now?

“My lifestyle now is very simple.

  • I use one credit card.
  • If I can’t afford something, I don’t buy it.
  • I shop at thrift stores, make curtains, paint, have learned some electrical skills and can do just about anything.

Having made the financial changes, I now have the opportunity to travel. I have investments and simple monthly debt. My credit score is very high and I am able to contribute to my savings account and an IRA on a regular basis.”

What Advice Do You Have?

“I learned these financial lessons that might help your readers:

  • Always know your cash position whether or not you are wealthy.
  • Have a good grasp on your finances.  Knowledge is power.
  • Cash is king.
  • Know your financial position at all times.
  • Stay away from credit cards and their incredible interest rates.
  • Save and keep adding to your retirement.”

Closing Thoughts from Susie Q

You’ll notice that my friend’s financial lessons learned are similar to themes you’ve seen in posts I’ve written, especially in the post on advice we gave our kids.

Her story, though, provides real-life insights into why these actions are so important.

You’d never know if you met my friend now that she had to make such a long recovery from financial disaster. She is always upbeat, willing to lend a hand and a great motivator. In fact, she contributed to the initial costs of this blog because she was so thrilled that I am willing to share my knowledge with others to help them be financially literate. I hope I am as resilient as she is if I ever face an equally daunting challenge.

The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

Examples

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1 Balance Due Interest Rate Minimum Payment
Debt 1 $1,500 20% $30
Debt 2 500 10% 10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2 Balance Due Interest Rate Minimum Payment
Debt 1 $1,000 10% $40
Debt 2 500 0% 25
Debt 3 10,000 20% 100
Debt 4 3,000 15% 75
Debt 5 750 5% 30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

In this example, you will make the additional payments on your debts in the following order:

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Comparison

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1 Example 2
Interest Paid Months of Payments Interest Paid Months of Payments
Snowball $428 25 $5,800 43
Avalanche 352 24 5,094 41
Difference 74 1 706 2

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

 

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

 

Credit Cards: What You Need to Know

Credit-Cards

Credit cards are a terrific convenience but also can be very costly.  Effective use of a credit card can make life easier and improve your credit score.  On the other hand, it is easy to buy more than you can afford using a credit card, leading to high interest charges and a lower credit score.  The latter process can lead to a downward spiral as the purchases you couldn’t afford lead to ever increasing finance and interest charges on your credit card.  At the same time, your credit score goes down which increases the interest rate on other loans, if you can get them at all as discussed in this post.

In this post, I’ll explain how credit cards work, including how finance and interest charges normally apply.  Every credit card is different, so you’ll want to look closely at the terms of any credit cards you currently carry or for which you plan to apply.

How They Work

When a financial institution issues you a credit card, it is offering you a loan in an amount that you can choose based on the amount of your purchases up to your credit limit.

Credit Cards from Your Perspective

From your perspective, you:

  • Pay the annual fee, if there is one.
  • Make purchases or get a cash advance. When you get a cash advance, you are borrowing cash from your credit card company instead of borrowing money to buy something.  You can get a cash advance at an ATM, among other places.
  • Pay your bill – hopefully the full amount every month, but at least the minimum payment if at all possible. If you don’t pay your bill in full, issuers will add interest charges to your next bill, as discussed below.  If you don’t pay as much as your minimum payment, they will also add finance charges.
  • Get rewards. Many credit cards provide rewards in the form of cash back or “points” that can be used for travel or other purchases.

In addition, you have the option to transfer your balance from one credit card to another.  Many people make this type of transfer when they have at least one credit card with a very high interest rate and one with a low interest rate.  By transferring the balance from the high-rate card to the low-rate card, you can reduce the amount of interest you will pay.  Most issuers charge a fee of roughly 3% of the amount transferred when you make a transfer.  If your interest rate decreases by more than 3 percentage points and you are paying off your credit card debt fairly slowly, though, your interest savings will be more in one year or a little longer than the transfer fee. As discussed below, though, the transfer could impact the interest charged on other purchases, so you’ll want to look at the whole picture before making a transfer.

Credit Cards from the Issuer’s Perspective

Income

The credit card issuer generates revenue from several sources:

  • Your annual fees.
  • Interest and financial charges you pay.
  • Fees it receives from vendors who accept their credit cards. Most issuers require vendors to pay them 2% to 4% of the amount of your purchases.  Recently, some vendors have started passing these fees on to customers.  That is, they charge customers who use credit cards more than customers who use a check or pay cash.  I ran into that when paying for many of the costs of our daughter’s wedding.  To keep the cost down, I made sure I paid any vendors who charged these fees using an electronic transfer.
  • Finance charges. If you don’t make a payment toward your credit card bill at all or the amount you pay is less than the minimum payment, issuers charge you a fee in addition to the interest charges.
  • Cash advance fees.  Many issuers charge $10 to $25 or 5% of the amount every time you get a cash advance.  I never use my credit card for a cash advance as 5% of the cash is a steep charge to access cash.  There are emergencies, though, when having cash at any price is imperative.
  • Foreign transaction fees. Many issuers charge fees when you buy something outside your home country.  I carry two Visa cards one of which charges me 3% on my purchases every time I leave the US.  For years, I carried only one credit card but I was leaving the US for a month to travel and decided I wanted a back-up card.  I went to the bank where I keep my checking account and clearly didn’t read the fine print! In hindsight, it was silly to get a back-up credit card for travel with such a high foreign transaction fee.

Issuers’ Expenses

Credit card issuers have four primary expenses – their overhead costs (salaries, rent, etc.), the cost of the rewards they give customers, the cost of borrowing the money that they “loan” you between the time you make a charge and pay your bill, and the amount of money they have to write off because customers don’t pay their bills.

When Do You Pay Interest

If you pay your credit card bill in full every month, you don’t transfer a balance from another card and you don’t get a cash advance from your credit card, you won’t pay any interest.   When you do any of those things, you’ll get interest charges.

Interest on Unpaid Balances

You pay interest on unpaid balances from the day they are due until the day the issuer receives your payment for those charges.  Once you haven’t paid your previous bill in full by its due date, though, the issuer starts charging interest on the day you make each future purchase rather than starting on the day the bill is due until all charges have been paid in full.  I’ll provide an example of this difference below.

Interest on Cash Advances

You pay interest on cash advances from the day you withdraw the money until the day the credit card company receives your payment.  I looked at one of my credit cards and it has a higher interest rate on cash advances in addition to having interest charges from the date of the withdrawal.  The same is true with other credit cards I’ve seen on line or discussed with my friends.

Interest on Balance Transfers

Some issuers allow you to transfer the balance from one credit card to another. You might want to do this type of transfer if the interest rate on one card with a balance is significantly higher than another card you hold.  When you make this type of transfer, the issuer starts charging you interest on the day of the transfer and continues to do so until you pay the balance in full.

In addition, even if you had previously paid off the balance on the card to which you transferred your balance, you will pay interest on all new purchases starting on the date of purchase.  That is, until you have fully paid off your credit card balance including the amount transferred, you do not get a grace period between the date of purchase and the due date of your bill.  The additional interest could offset some or all of the savings you attain by reducing your interest rate when you transfer a balance.  This article from creditcards.com provides more details about some of the risks and benefits of transferring a balance.

How Is Interest Calculated

Still confused about how and when interest is calculated?  Hopefully these examples will help.  Before going into the examples, I need to explain what the interest rate or APR (annual percentage rate) really means.

A 24% APR, for example, doesn’t mean you pay 24% interest if you carry your balance for a full year.  The 24% is divided by 365 (number of days in a year) to get a daily rate.  The daily rate is multiplied by your balance on each day and added to the balance for the next day.  As such, if you didn’t pay or charge anything on your balance for a year, the interest rate on the beginning balance would not be 24%, but rather 27.1%!  I calculated 27.1% as (1+.24/365)365 – 1.  By raising the term inside the parentheses to the 365 power, I’m compounding the daily interest charge for a full year (365 days).

Example 1 – Paid Bill in Full Last Month

In the first example, I’ll show how interest is calculated if you paid your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Cash advance interest rate = 24%
  • The cash advance fee is the greater of $10 or 5% of the amount of the cash advance
  • You make a $500 purchase on Day 5
  • You take a $100 cash advance on Day 8
  • Your issuers receives your payment on Day 10 of the next billing cycle (i.e., 33 days after you took the cash advance)

In this example, you don’t pay any interest on the $500 purchase during this billing cycle.

The cash advance is different.  First, you are charged the cash advance fee.  5% of your cash advance is $5 which is less than the $10 minimum, so you will be charged $10 as a cash advance fee.  In addition, you will pay interest at a 24% APR.  The interest charge is $2.19 which is calculated as:

As such, you will re-pay the issuer $112.19 for the $100 cash advance you received. This example illustrates why it is often better to tap sources of cash other than your credit card, if at all possible.

Example 2 – Didn’t Pay Bill in Full Last Month

In this example, I’ll show how interest is calculated if you didn’t pay your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Unpaid balance from last month = $750
  • You make a $500 purchase on Day 5
  • Your issuer receives your payment in full on Day 10 of the next billing cycle

I haven’t included a cash advance in this example because it will cost you the same amount regardless of whether you paid your bill in full in the previous month.

In this example, you will pay interest on your unpaid balance for the 30 days in the month plus the 10 days into the next billing cycle, for a total of 40 days. The interest on this balance totals $14.93 and is calculated as:

In addition, you pay interest on the $500 purchase for 25 days in this billing cycle plus the 10 days in the next billing cycle, for a total of 35 days.  The interest charge on this purchase is $8.70 for a total interest charge of $23.63. If you have gotten behind on your credit card balances, check on this post for strategies that will help you get caught up.

The Best Credit Card for You

As with every financial decision, picking the best credit card for you requires balancing the costs and benefits.  In large part, the best credit card for you depends on how you will use it.  The bottom line is that you want the credit card that will have the greatest net benefit or lowest net cost for you.  Here’s how you can calculate that benefit/cost.

Plusses

The plus in the equation that determines your net benefit is the value of any rewards you earn.  Some credit cards provide no rewards, so the total plusses equal 0.  Other credit cards provide rewards, such as  1% of all purchases or 5% of gas purchases plus 3% of food purchases plus 1% of everything else.

To calculate the value of the benefits, you’ll need to estimate how much you expect to charge on your credit for each category of expense.  You can then multiply those benefits by the corresponding reward percentage.  As an illustration, I’ll use the 5% for gas, 3% for food and 1% of everything else example I mentioned above.  The table below shows three different combinations of monthly expenses in those categories and the rewards you would earn.

Category Scenario 1 Scenario 2 Scenario 3
Gas 100 200 500
Food 300 500 300
Other 600 300 200
Monthly Rewards 17 23 33
Annual Rewards 204 276 396

By comparison, you would receive $10 a month or $120 a year with a credit card that provides 1% back on every purchase under all 3 scenarios.  I note that most credit cards do not give rewards for cash advances, so I have not included them in the table above.

Some rewards are harder than others to access or might be in a form that isn’t useful for you.  If that is the case with one of the credit cards you are considering, you might reduce the annual benefit by some amount, such as 50%, for the chance that you don’t use it.

Minuses

Offsetting the rewards are all of the fees and charges I mentioned above – the annual fee, cash advance fees, finance fees, foreign exchange fees and interest charges.

The table below shows the fees I’ve used for illustration for the two cards above.

Rewards 5%/3%/1% 1%
Annual fee $75 $0
Cash advance fee $10 $10
Cash advance APR 24% 18%
Purchase APR 18% 12%

To keep the examples simpler, I’ve assumed you make at least the minimum payment every month so there are no finance charges and you have no foreign transactions.

Example 1

In the first example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  You pay your bill in full every month.

In this example, your annual costs are $243 using the higher reward card and $150 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards, remembering that the lower-reward card has the same rewards under all three scenarios.  A negative net cost means that you pay more in fees than you get in rewards, whereas a positive net cost means you get more in rewards than you pay in fees.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -243 -243 -243 -150
Net Cost -3 +93 +189 -30

 

In this example, you don’t incur many fees, so the lower fees in the lower-reward credit card don’t help you.  As such, you are better off with the higher-reward credit card under all three spending scenarios.

Example 2

In the second example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  Unfortunately, you got behind on your credit card payments so you average 60 days between the time you make each purchase and take out your cash advance and pay your bill.

Your annual costs are $652 using the higher reward card and $379 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -652 -652 -652 -379
Net Cost -412 -316 -220 -259

 

In this example, the lower-rewards credit card has a lower net cost than the higher-rewards card, unless you buy a lot of gas in which case you are somewhat better off using the higher-rewards card.

Summary

This comparison illustrates that high-rewards credit cards are not always the best.  To select the best credit card, you’ll want to balance the fees you are likely to pay based on your spending and payment patterns with the available rewards and their usefulness to you.