When merchants accept payment via credit card, they are required to pay a percentage of the transaction amount as a fee to the credit card company.
If the cardholder has a participating cash back rewards program, the credit card issuer simply shares some of those merchant fees with the consumer. The goal is to incentivize people to use their credit cards when making payments rather than cash or debit cards, which earn them no rewards. The more a consumer uses a credit card, the more merchant fees the credit card company can earn. Most cash back rewards cards pay somewhere around 1% to 2% in cashback, with some paying as much as 5% depending on location and card type.
Credit card issuers make money from three main sources: Interest. Fees. Interchange.
The more consumers use their credit cards, the more likely it becomes that they will miss a payment or carry a balance for which they will owe fees and interest.
According to the Federal Reserve, the average credit card interest rate is 16.61% as of Q1 2020. The Federal Reserve also reported almost $1.07 trillion in outstanding revolving credit by March 2020. Approximately 45% of credit cardholders carry a balance from month to month according to the latest Federal Reserve Survey of Consumer Finances.
For example, if you have a flat-rate 2% cashback card and spend, say, $1,000 over the course of a statement period (about one month), at the end of the statement period you would have earned $20 cashback, however, if you only pay the minimum balance on a $1000 balance, you will owe somewhere around $1,160 by the next month, completely negating any savings you earned.
If you truly want to benefit from your rewards credit card, you shouldn’t carry a balance and you shouldn’t pay any avoidable fees, particularly late fees. If you’re shopping for a new rewards card, look for one without an annual fee, unless you’re sure the rewards you’ll earn will more than offset that cost. For example, Jetblue has 2 credit card options, a base card, and a “premium” card. The first is free, with no annual fees, and earns you mileage with their airline at a certain percentage depending on the type of bill paid. The premium card has an annual fee of $99. If you earned less than $99 worth of rewards that year, you negate your entire earnings on that one payment alone, let alone if you are carrying a month-to-month balance. This card only works for someone who spends and flies Jetblue enough to maximize at least $99 of rewards. Hopefully more, seeing as no one wants to simply break even on their rewards. Even though the free card may offer fewer benefits upfront remember to always account for how much you will be using the card, where, and why.
Category Bonus Cash Back-
Category bonus cash back cards offer the lure of 5% cashback from revolving spending categories. These categories are typically set by the issuer every quarter and are usually released a few months before the new quarter starts. Five percent back can be a nice haul if you’re able to max out the spending categories each quarter, but it takes a bit of work.
First, you have to register for the bonus categories every three months, and spending in the categories is capped at a set amount each quarter (typically $1,500 in purchases). Since any purchase not in the bonus category earns 1%, you may not be getting the average return you think you are.
Tiered Rewards-
Like category bonus cards, tiered rewards cards offer more cashback in select spending categories, but to maximize your earnings you have to think about which card to use with each purchase.
There is a wide variety of categories for which you can earn that 5%, including restaurants, gas stations, grocery stores, select travel and transit, select streaming services, drugstores, home improvement stores, fitness clubs, and live entertainment.
Flat Rate Card Reward-
With simple cash back cards, also called flat-rate cash back cards, you earn a flat percentage with every purchase. There’s no need to track and activate bonus categories. You earn the same cashback on every purchase.