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How Do Cash Back Credit Cards Work?

Most people expect using credit cards to be a rewarding experience. A survey of consumer card preferences by Total System Services, Inc., found that a rewards program is the most valued feature on a credit card, ranking ahead of the interest rate charged on unpaid balances.

Cash back is the king of rewards. Among consumers whose go-to credit card in heaviest rotation is a rewards card, nearly 70% are earning cash back, according to Total System Services’ survey.

Cash back can indeed be a rewarding way to wring extra value out of a credit card. Redeeming cash rewards can often be easier than jumping through the blackout period hoops to redeem travel reward points. Cash rewards can also make it easy to stay on top of your credit card bills, as you can have your cash back rewards automatically applied to your credit card balance. If that helps you pay down your card bill, that may help improve your credit score, as well. (Learn more about how lower credit card balances can improve your credit utilization ratio, one important factor in computing your credit scores.)

Understanding the key features of how cash back works can help you zero in on the rewards plan that has the potential to deliver the most cash back to you.

Sweet Deal: Get Paid When You Spend

When you make a purchase with a cash-back rewards card, you earn a cash credit for a percentage of the purchase. Typically you might earn 1% to 2% on all your purchases. Some cash-back plans also offer a higher payback on a specific spending category. For instance, you might be able to earn 3% back on your gas purchases.

Many cards also offer a special spending category that rotates each quarter, where the cash back rate can be 5% or so. For example, you might get 5% back on grocery spending this quarter, and then next quarter your grocery payback reverts to the typical standard rate of 1% or 2%, and another category, such as restaurant spending, earns 5%.

You typically need very good credit scores to qualify for a cash back card that offers a strong rebate deal, and a low-interest rate (APR) on unpaid balances.

Sizing up a Cash-Back Rewards Offer

Knowing the ins and outs of how a specific cash back offer works can help you find the deal that makes the most sense for your spending and charging habits. Questions you’ll want to consider:

  • Will your potential rewards offset the card fee? Paying a $75 or $100 annual membership fee might not make sense if you will likely earn less than that in cash back for the year. If the card waives the fee in the first year, be sure to check what the fee might be in subsequent years. Keep in mind that pocketing the most value from a cash-back offer requires being extra careful with how you handle your card payments. One late-payment fee can run $35. If you have two late-payment charges in a year on a cash-back card that earns you 1% back on your purchases, you would need to charge $7,000 just to offset the $70 cost of the two late fees. Added injury is that late payments can also negatively impact your FICO Score.

If you anticipate you might not pay off your balance in full each month, you will also want to compare the interest rate charged on a cash-back card with other cards. Paying a higher interest rate can quickly outstrip the value of cash-back rewards.

  • What is the limit on the juicy payback offer? Often, a 5% payback rate comes with a spending limit. For instance, you might get 5% back for a quarter on the first $2,000 you spend in a featured category. That works out to a nice $100 cash back reward for the first $2,000. But then any additional spending in that category may revert to the “standard” rate the card pays on all other purchases, say 1%. So, if you were to spend $3,000, you would earn a total of $110: $100 from the first $2,000 of your spending earning a 5% cash back reward, and then $10 from the next $1,000 in spending that earns 1%.

If you are intrigued by the rotating spending categories that can earn juicy cash-back points, size up how much effort you might need to put in to be eligible for the fat payouts. It’s common to require card holders to sign up each quarter for the big payback offer.

  • Will You Be Tempted to Spend More on High-Rebate Categories? If you know there is a higher payback rate for a category, would that make you more inclined to spend more than you might otherwise? Spending $2,000 in a category that you typically might spend $1,500 in without the extra enticement, is likely not going to pay for itself with the cash back reward.
  • Will the Card Still be Worthwhile After the Initial Sign-up Enticements? Many cards offer a cash bonus of $100 to $200 when you start using a cash-back card. Make sure you understand how much spending you need to do-and in what time period-to earn the bonus. For example, you might need to spend $1,000 in three months to earn a $100 bonus. And think through what happens after that first-year bonus. If the card pays you a flat 1% cash-back reward, you might be better off in a card that pays you 2% or more the first year, and every subsequent year, even if the sign-up bonus isn’t as high.

It’s also common for cash-back cards to offer a low interest rate on unpaid balances-and balance transfers-for the first year or so. If you anticipate carrying a balance past the intro period, you’ll want to size up whether that “normal” rate is competitive with other credit cards.

How to Cash In on Your Cash Back Rewards

Each credit card issuer has its own rules on redeeming. It’s worth spending a few minutes focusing on the fine print to understand the rules for cashing in. Some cards guarantee your cash back rewards will never expire, others might require you to redeem your cash back within a year or two. You might also need to make at least one charge on the card each year—not exactly a very high or hard hurdle-to keep your rewards points. If you ever are pondering cancelling a credit card—a move that should be done only after careful consideration because it can negatively impact your credit scores – be sure to check what will happen to any unredeemed cash-back rewards.

Some cards offer multiple ways to redeem, others stick to one option. Common ways to cash-in:

  • Apply the Cash Back as a Credit on Your Card Statement. It’s no secret that running a credit card balance can be quite expensive. Recently, the average interest rate charged on unpaid credit card balances was around 14%, with a top rate that can be more than double that amount. Using a cash-back reward to pay down your credit card balance can be a valuable debt-reduction strategy.
  • Have a check mailed to you, or arrange for a direct deposit payment into a checking or savings account. Some banks offer bonuses if you deposit the money in one of their checking or savings accounts.
  • Get a gift card. You might be able to get your cash-back as a gift card for a popular retailer such as Amazon.com.

Earning money back when you spend money is clearly a rewarding experience. Knowing how cash-back rewards cards work puts you in the driver’s seat to find the offer that best fits your needs.

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