Today’s lesson is on the spoils of my experiments opening 17 credit cards. I always recommend my friends open credit cards due to the lucrative possibilities they entail, including rewards and what amounts to a free ~30 day loan on all purchases. They serve the added bonus of boosting your credit score when used properly to save you money on home or auto loans down the road. This tutorial is targeted to beginner and intermediate credit card aficionados. (Full time credit card churning pros probably know all this already 😉

The Basics

To really understand credit cards, you have to understand why they exist.

Why does a bank want you to open a credit card with them?

The answer: Banks to make a lot of money off of you when you use their credit cards. Every bank has a team of people that are employed to analyze you, your habits, and your desires and to adjust rewards, interest rates, and promotions to extract the most amount of money in fees and interest as they possibly can from YOU. It’s similar to a casino — the slot machine is perfectly timed and designed to get you addicted and (legally?) steal your money.

But fear not: many people (like me) make a lot of money by using credit cards for their ordinary purchases — rewards credit cards can be very profitable if (and only if) used correctly. Promotions available when opening cards can net you several hundred dollars; using regular credit card rewards can earn a minimum of 2% cash or points back on every credit card-able purchase you make the rest of your life. 

A Few Examples

1. Opening a credit card through Chase like the Ink or Sapphire can net you a $500 bonus just by making your ordinary payments using the card, and this is on top of earning 1-5% back on every purchase (1% typical, 2-5% bonus categories). The money is also worth 20% more when redeemed for travel.
2. Citi’s DoubleCash card earns you a full 2% cash back on every purchase you make.
3. Discover It has a rotating 5% promotion on Gas, Restaurants, Amazon. Amazon’s own visa nets you 3% back on their site.
4. TD Bank Cash Rewards offered me (in what appeared to be an invitation-only offer) $200 rewards after $500 spend on top of 5% promotional cash back on a crap ton of categories for 6 months.
5. Many other cards have $100-$300 promotions (BoA Travel Rewards, Amex Business Cashback, etc) but may not be worthwhile to use after said promotional spend is satisfied.

TL;DR I made over $1000 in credit card promotional offers last summer, and you can too!

(Yes it was a huge time sink but in the words of my dad, “It’s a lot better of a way to waste time than video games.”)

The Catch

Of course we all know that most people lose money on exactly the same credit cards. I know people (who may or may not be in my family) that lose thousands of dollars a year to interest on revolving accounts. The difference between making money off a credit card and losing thousands of dollars in interest payments is pretty subtle, so listen carefully and I’ll cover credit cards from top to bottom.

The reason people fall victim to credit cards is pretty simple: we are all basic, lust-filled beings that succumb to desire and eschew basic logic. As long as you feel comfortable that your logic can outweigh your desire to buy lots of shiny things you shouldn’t have a problem (on the other hand, if not…).

The Golden Rule

Credit cards are a really bad choice to live outside of your means (not that there’s a good way to do so, but there are better ways). Follow these guidelines for trouble-free use of credit cards:

1. Always pay the balance on the statement in full by the payment due date every month; the credit card is free if and only if you do this.
2. Set up autopay to make it hassle free. Keep tabs on cards that don’t support autopay and use eBill.
3. Never use credit cards to spend outside your means. If you have $500, only spend $500.
4. Temporary conditions may necessitate more capital than you currently have. If this is the case, a loan is the way to do so.
5. Using a rewards credit card for your ordinary purchases can make you money. Maximize your rewards by matching rewards credit cards to categories.

Remember that living outside of your means is a very temporary condition. At best you can spend up to your credit limit and declare bankruptcy (which is no fun) so far better to manage your finances actively 😉

The Danger of $1: Meet Bob

A credit card operates on the principle of credit — let’s follow my mythical protégé Bob who just appeared in this world and has $0 to his name on the first day of the year.

Bob can go get a job and make $1000/month, but he won’t earn that money until the 14th day of the year because Massachusetts labor laws say that any employee who is not a “bona fide” professional must be paid every two weeks and not semi-monthly because Massachusetts legislators enjoy causing accountants unnecessary pain.

Well here is a problem: Bob is hungry and would like to eat for the first two weeks of his life, but Bob doesn’t yet have any money. One way to bridge this gap is to use a credit card.

On day 1, Bob opens a credit card account and starts his job. During the first two weeks of the month Bob spends 14/31sts of his paycheck on this credit card. So that is….alright you know what, fuck you Massachusetts, Bob will be paid semi monthly. On Firstuary day 15 Bob will be paid $500 for a half-month’s wages (yes, Bob now lives in Italy and pays no taxes), and Bob has accrued a balance of $500 on his credit card.

Psychologically, standing in Bob’s shoes you think: huzzah, I am rich! I have $500. The truth is that Bob’s net worth is now $0, because his $500 in the bank is offset by his $500 credit that he owes the bank on your credit card.

What’s the good news? That $500 is now earning an earth-shattering 1% interest in his bank account. Go you! That will earn a whole 42 cents of interest over the next 30 days. Less staggering but important nevertheless.

(But extend this principle: suppose Bob’s monthly spend was $10,000 — credit cards would allow him to keep more money in his Lending Club investment account earning 8% interest.)

Let’s continue. At the end of the 30 day month, Firstuary, Bob now has $1000 and has amassed a $1000 balance on his credit card. He still has $0 of net worth. Actually that’s not quite true — he has just earned 20 cents of interest on his $500. His bank hands him a statement to say that his credit card balance is $1000 and he must pay at least the minimum $35 payment by the 21st day of Seconduary.

Route 1 (the scenic coastal route): Bob paid attention to me

Let us suppose Bob enrolls in autopay. On the 21st day of the month (the due date), the bank automatically sucks $1000 out of his bank account to pay the credit card balance. In this time Bob has earned just over 60 cents of interest by having his credit card. The process repeats indefinitely: Bob will reach $1500 in his bank account by 2/15, after which he will fall back to $500 just as in Firstuary. He has been given a temporary extension to pay his bills, but this only helps him “once:” the amount of money he pays is exactly the same as the amount he spends, but it is offset by an average of 36 days (or so) from when he actually made the purchase.

The credit card is effectively free as he will never pay any fees or interest. Bob makes money both of the additional interest on the savings account as well as any rewards: he would earn $20/month on a 2% cash back card — not bad at all (of course, this money is sucked out of local business who pay a 2% interchange (and related garbage) fee to accept the card as well as other poor souls who don’t use credit cards properly, but Bob is selfish and does not care about this non-trivial wealth transfer).

Bob does not care about the APR rate on the card. Once again: in the sole case that Bob pays the entire balance off in full every month by the payment due date (which is about 21 days after the statement date), the credit card never charges Bob any interest. This is called a grace period. But:

Interstate 93 Southbound during any reasonable hour: Bob ignored this article

Let us say that taxes happened and Bob actually only had $999 in his bank account. Instead of paying the full balance, he pays all but $1.

“That’s fine,” you say, “because he paid off almost the entire balance so he will pay interest only on the $1 which can’t be that much.”

You would be very, very wrong about that fact. Because the balance is no longer paid in full, something interesting happens: the grace period disappears.

Bob is now charged a “crap ton” of interest. Just because he left $1 on his account, he will now be charged interest on each new purchase starting on the date the purchase is made. He will pay interest on his $10 taco on day 1 of the new period all the way up until the day he pays his bill. It is weird because this is a binary switch — $1 less than the statement balance triggers interest on all the purchases made during his next statement period, even if he then pays the full balance the next month.

Some might call this weird or deceptive or a bizarre technicality (and of course it is) but again let us remember the reason this credit card exists is to make money off of you and that this bank employs many highly-paid statisticians to make money off of you and they are succeeding if you don’t pay off that last dollar.

Bob Chooses a Card

“This is awesome, a rewards credit card can make me so much money!”

So true. But let’s put numbers to the situation: “Reward credit cards” garner higher interest rates to offset the rewards they pay you. The Citi DoubleCash charges me 25.49%, for instance (though I have never and will never pay a cent of interest). To a first order approximation, assuming a roughly constant rate of purchase and that Bob pays in full on the 21st day of the Thirduary, he will have been charged an average of about $21.50 in interest on the purchases made during Seconduary, all for only $1 in unpaid balance the month before. This more than offsets his $20 made in cash rewards.

For comparison, a credit card without rewards like a USAA Platinum Visa garners only around 10% interest (for those lucky enough to have a familial relation who did a stint in the DoD). I would have only paid $8 in interest for the same period with such a card. Notice that while the rewards credit card may have originally looked like a good idea, the most basic and most minimal mistake you could make using said card nearly entirely offset its benefit.

Of course, I have not even touched the damage made by leaving a balance of greater than $1 on your card. As you can see, the picture gets far, far worse. Even if Bob stopped spending, he would pay $291 leaving $1000 balance on his card for a year (not to mention that leaving a balance on your card trashes your credit score — see the next section).

Note that the crafty credit card company  (the CCCC) designed that rewards credit card because they realized that through providing the positive psychology of a “reward,” people would ignore the fact that they were losing many times more money through additional interest. This little visible bonus offset the greater loss in terms of the bizarre nature of human psychology. For whatever reason, humans are very bad at doing basic math.

Modern credit card statements have to give you a lot of information about the fees and interest they charge and a lot of simple education, but you still have to read the fine print.

If Bob really needed “help,” he could get a loan for less than 10% APR (but ONLY if Bob has a good credit score). If you temporarily need more money than you have, getting a short term unsecured loan is the best option. Why?

Credit Scores

You may notice that when you go to get a loan, the APR or interest rate charged can vary wildly. This is because lenders vet their debtors through an algorithm called a “Credit Score.” Every human gets one of these numbers, and it varies arbitrarily between 350 and 850.

The system has been accused of being very opaque, but certain regulations and new startups make it a lot easier to find (and correct) pertinent information.

If your score is lower, you are assumed to have greater risk of default. Accordingly, your interest rates are adjusted upwards from the base rate to offset your risk: the additional money they earn from you is (in an ideal world) to increase their income commensurate with your risk of default.

It should not surprise you, therefore, that maximizing your credit score can save you a lot of money in interest when taking out a loan. From the credit card perspective, this matters less save that you may not qualify for more competitive credit cards without maximizing your score.

The formula is (unfortunately) pretty dumb, but that also means it’s easy to game the system if you know what you’re doing. Major factors are number of accounts, average age of accounts, and credit utilization. Also, the credit bureau keeps track of how many institutions have requested your credit to open new accounts, and pulls within the past year decrease your score.

Playing the Credit Score Game

1. Keep tabs on the system. Use a credit card monitoring service like Credit Karma to see your credit and utilize the Free Annual Credit Report. In particular, monitor for any strange accounts and number of hard credit inquiry.
2. Open one credit card about every six months, starting on your 18th birthday. Your first credit card will probably have to be secured (backed by a security deposit) or be with a bank at which you have a savings account or other relationship. If you get a loan or other account, you should skip the credit card for that six month period. You need not use every card all the time — you can just use one at a time. You want to open store or ordinary/rewards credit cards; never open credit cards that have annual fees unless you have a clear reason to do so (there are great benefits, but not every card is appropriate for every user at every life point). Never (and I mean never) close a credit card account that doesn’t charge an annual fee. Pay it off and cut it up. It makes sense that the system prioritizes number of accounts and length of history but the number of accounts is a bit absurd (>20 is the excellent category).
3. If your credit report lists an account as inactive, make a single purchase with your card and pay it off to reactivate it.
4. Use a software like Quicken to keep tabs on your finances. It will help you by adding your credit card balances and cash on hand to give you net worth. Never spend more money than you have using credit cards, get a loan instead.
5. Never miss a payment. Use eBill from your bank account to get all the bills sent to your checking account bill pay page. Enroll in AutoPay to make automatic payments and keep track of the few cards that don’t support AutoPay (or don’t use the cards and banks at all — cough, Bank of America, you evil souls).
6. Avoid requesting credit limit increases that incur hard credit pulls. Most of the time you can get a credit limit increase if your income increased or if your score has increased. The bank will utilize their periodic “soft pulls” (which they do usually every statement just to “see how things are going” and do not affect your score). The bank has to tell you when they will do a hard credit pull, and you can even call and request that the increase not be processed if it incurs a hard pull.

Subtleties: Statement Balances

Now the trick: high balances hurt your score.

In theory, if you always paid off every card in full every month the score would not penalize you for spending money. This is not the case, because the formula is stupid. Each credit card reports your balance to the credit bureaus at the statement date (the same figure that appears at the top of your statement on the date the statement period closes) and balances in excess of 30% or even 10% of your credit limit hurt your score. This is only temporary — pay off the balance and the score will bounce right back. So how can you make sure this doesn’t hurt you?

1. In the 30-45 days before opening a new account, pay off your balances before the statement date (log in and submit a payment online from the card issuer’s site that equals the balance on that date). This will deflate your balance and increase your credit score, sometimes substantially. Stupidly, you may want to leave a few dollars on your card at statement time because you’re also penalized for less than 1% utilization.
2. Small business credit cards have different reporting policies. Chase, American Express, and Bank of America (and probably most others) do not report these accounts except in case of 45 days’ (or more) overdue payment. If you primarily use a business card, such as the Chase Ink, for your regular purchases, your balance will appear to be very low even if you receive large statements from Chase Small Business. The flip side is that this account does not help your credit score, and it does incur a personal hard credit pull on opening just like any other card.
3. Increase your credit limits — having higher credit limits, or high credit limits in aggregate over many cards, decreases the significance of ordinary balances.

To be fair, the formula is pretty accurate in terms of ranking likelihood of default but it also stupidly penalizes buyers for certain typical credit card usage patterns.

Loans vs Revolving Credit

The credit score system is designed to penalize high use of credit cards or “revolving credit” accounts. This maybe makes sense.

Confusingly but importantly, if you take out a loan your score improves.

Max out a $5,000 credit card and your score goes into the toilet; borrow $10,000 in a 36 month unsecured loan (moving your debt over and use the remainder to invest in your small business empire) and your score improves dramatically.

Making no sense? Good, it’s not designed to. You just have to play the game.

Promotional APRs

A few last words on the gimmicks: Be careful with Introductory APRs, deferred interest, and balance transfers. There is an appropriate use for some of these, sometimes.

Introductory APRs will give you a lower rate on either Purchases or Balance Transfers for a period of time before returning to the regular APR. For instance, a credit card might give you 18 months of 0% APR for purchases when you open it. This means that when you make purchases, as long as you continue to make the minimum payment, you will not be charged interest on those purchases until such a date. This will be clearly printed on your statement, along with a date or billing cycle after which the intro APR will end. This introductory purchase APR will not apply to balance transfers or cash withdrawals, which have a separate APR also delineated on your statement.

Be very careful leaving a balance on a Promotional Purchase APR because you will have to pay the whole balance off eventually. Appropriate uses for such a balance would be to invest the money temporarily as long as you were confident in having sufficient liquidity to pay off the balance in time, or if you are (like me) currently a student wanting to take vacations but have signed a full time job offer and know that you’ll have money when the time comes to pay the fiddler. (Live on the edge, amirite?)

Promotional Balance Transfers have a greater downside. The terms can be shorter, but also you typically must still pay a balance transfer fee. For example, you’ll typically find 2-3% fee paid at transfer to gain the 0% APR for ~12 months. These are probably never a good idea, though you could hypothetically use it to increase your investment portfolio as long as you felt sure about beating 3% returns.

Understanding “Deferred Interest”

We’ve all seen those offers from Home Depot or Best Buy which say something like “no interest if paid in full within 18 months.”

Note the very important “if.”

This is very, very different from a promotional 0% APR. You’d probably find that the APR on such things was actually 18%. The catch is that if and only if you pay the entire balance off by the midnight hour of the statement period of the 18th month, you will not incur interest.

Should you fail to do so, you will be billed ALL OF THE INTEREST RETROACTIVELY back to the purchase date, which is not fun. Therefore it is important to understand these offers and only accept the terms if you’re 100% confident in your ability to pay the entire sum off by such hour.

Have Fun!

Hopefully I haven’t overwhelmed you with the intricacies of this game. The point of this article is to illustrate that credit cards can be very useful tools for you, or very useful tools for banks to extract money from you. Making sure you stay on the right side of the fine line is not that hard, so keep careful tabs and have fun playing the game!