8/5/2011 12:30 PM ET|
An 'island approach' to credit cards
Lower the cost of debt -- and maximize card rewards -- by using a strategy designed to help you get a better handle on your finances.
About 25% of American consumers had bad credit as of April 2010, according to the credit-scoring agency FICO. As of March 2011, Americans were also revolving more than $796 billion in debt -- almost all of which was credit card debt -- reports the Federal Reserve.
Clearly, people are having a difficult time managing their personal finances. The National Foundation for Credit Counseling's 2011 Financial Literacy Survey (.pdf file) found that 28% of American consumers admit to not always paying their bills on time, 56% don't have budgets and 22% don't have a good idea how much they spend on housing, food and entertainment. So, the Great Recession isn't all to blame.
Many of us need to change how we approach spending. We need financial discipline, clarity and a way to lower the cost of debt. When it comes to credit card use, one strategy that promotes each of these things is known as the island approach.
What is the island approach?
The island approach to credit card use was introduced by the credit card comparison website Card Hub and is built upon the idea of compartmentalization. It suggests that consumers segment their financial needs (for example: revolving debt, making everyday purchases and earning rewards) on different credit cards as if they were islands. But how does this approach promote financial discipline, the eradication of debt and the maximization of rewards? Let's find out.
According to the island approach, you should never revolve debt on the same card you use to make everyday purchases. Doing so simply makes it difficult to gauge whether your spending exceeds your means, because purchases get lost in the shuffle of debt. If you use one card exclusively to make everyday purchases, however, a balance at the end of the month is a clear indicator that you are overleveraged and need to adjust your spending habits. Once you do so and settle into a routine of paying for your purchases in full each month, the presence of finance charges on this account -- which should never have them -- will serve as a wake-up call that you are spending too much.
Minimize the cost of interest
Isolating different transaction types on different spending vehicles helps you lower the cost of debt in four ways. First, it allows you to get the lowest possible interest rate for each transaction. You may be able to find a single card with 0% on both purchases and balance transfers, but chances are that the card with the longest period of 0% annual percentage rate on purchases is different from the card with the longest period of 0% APR on balance transfers.
Second, it lowers your interest-bearing balance. If you use a single credit card to both make purchases and revolve debt, your interest-bearing balance is your debt plus the price of your purchases. When you use separate credit cards, however, only your debt will be the interest-bearing balance, because you pay for your everyday purchases in full each month and therefore never have an interest-bearing balance on your everyday credit card.
Third, if you are a small-business owner, the island approach provides debt consistency. Business credit cards were not included within the scope of the Credit CARD Act of 2009, which means credit card companies can apply increased interest rates to existing balances at will. They are legally restricted from doing so with general-use credit cards unless consumers are 60 or more days delinquent. Therefore, by using a general-use credit card to make purchases that result in an end-of-month balance and a business credit card for those that will be paid for in full by the end of the month, you can protect yourself from sudden cost-of-debt increases while at the same time still benefiting from the unique business-oriented utility that business credit cards provide.
Finally, the island approach is conducive to favorable payment allocation. When you hold multiple balances on a single credit card, only the amount of your payment above the minimum gets applied to the balance with the highest interest rate, meaning you will likely pay this balance down more slowly and spend more on interest. On the other hand, if you hold each of your balances on different cards, you can strategically make payments so as to minimize the cost of your debt and pay it down faster.
As with interest rates, you're likely to find a rewards credit card with pretty good overall benefits, but will you find one with the best travel rewards, the most lucrative gas discounts and the highest cash back earning rate on your biggest spending categories? Probably not. Under the island approach, however, such rewards maximization is possible. Simply evaluate your spending habits, identify your top expenses and get the credit cards with the best possible rewards for each. This allows you to both earn more miles, points or cash and redeem them frequently, thereby mitigating the risk of rewards devaluation and ensuring consistent benefit. Don't even think about rewards if you have debt and/or you don't have excellent credit, though; your focus should obviously be elsewhere.
Given the prodigious amounts of consumer debt and the unrestrained spending habits many of us exhibit, the status quo isn't cutting it. A change is needed, and for many of us the island approach is a great fit. Whether you need to get out of debt as quickly as possible or maximize your rewards, this approach to credit card spending can help you accomplish your goal. So take a trip to the islands, and credit card use will be a breeze.
This article was reported by Odysseas Papadimitriou, the CEO and founder of Card Hub, for Investopedia.
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Um, couldn't I get out of credit card debt by NOT USING CREDIT CARDS AND PAYING THEM OFF!
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