Here’s how cash back credit cards work
It’s no surprise that credit cards are integral to spending and managing your money. In fact, 84% of adults had a credit card in 2021, according to the Federal Reserve. Usage among those adults varies across income levels, with some tending to pay their monthly bill in full and others carrying a balance, but so does the type of credit card.
There are several types of credit cards, such as travel credit cards, business credit cards, student credit cards, co-branded credit cards, store credit cards–and, of course, cash back credit cards, which can be a worthwhile perk if you use it to your advantage.
What are cash back credit cards?
Cash back credit cards are a type of credit card that, through its rewards program, gives cardholders a percentage back on qualifying purchases. The amount varies by credit card, and the bank or financial institution issuing the card, but is typically around 1% to 5%, with simpler cards typically offering a flat rate of 1.5%. “Let’s say your cash back payout percentage is 1%, for every £100 you spend, you would get £1 in cash back,” says Brian Walsh, a certified financial planner and senior manager of financial planning at SoFi.
How do cash back credit cards work?
Cash back credit cards come in three main types: flat-rate, bonus rewards, and rotating category.
“With a flat rate cash back card, you essentially have the simplest credit card that you can have, from a rewards perspective.” Walsh says. “You have a specific percentage that’s going to apply to all of your spending.” Flat rate credit cards typically work out well for most people because it allows them to take advantage of all their spending, regardless of what you’re using the card to buy. For the bonus rewards type of cash back credit card, it’s “going to pay out different percentages, depending on what you’re spending your money on,” Walsh says. That means that you’ll be earning more on specific categories, like travel or dining, and less on everything else.
Finally, for credit cards with rotating categories offer different bonus categories (that typically change monthly or quarterly) to cardholders, but they may require manual activation to start earning cash back. Michael Ashley Schulman, CFA and partner and chief investment officer at Running Point Capital Advisors says it’s important to keep an eye out so you know what categories will earn you more or so your unused points don’t go to waste. Nonetheless, cash back can be redeemed in a variety of ways depending on the card itself.
That means you can redeem your earned cash back for statement credit or deposit it into your checking account. Some other options for redeeming cash back include: redeeming for gift-cards, requesting a check, using it to offset a large purchase, paying specific retailers with points you’ve earned, and booking flights or hotels.
How to choose the best cash back credit card for you
Start by looking at how you’re spending your money. When shopping around for the best cash back credit, you should start by looking at how you’re spending your money because it’s important to understand the broad categories that your spending applies to. After that, think about how you’d like to use the rewards you’d get back.
“Then pair how the cards align with both how [you] spend money and how [you] want to use the rewards,” Walsh says. For instance, if you’re spending most of your money on groceries, you might want to consider a card with higher rewards for purchases made at your local grocery stores. That way, you’re taking full advantage of what you’re spending on and the rewards offered.
Decide whether you want a cash back credit card with a flat rate or a tiered rate, then decide if you’d like fixed or changing categories. So after looking at your spending, decide whether you want a flat rate cash back credit card or one with a tiered rate, and decide whether you want a cash back credit card with fixed or changing categories. After making those decisions, you can factor in annual fees, welcome bonus, and options for redeeming cash back. It’s important to note that cash back credit cards are best suited for someone who can pay their bill on time and in full each month.
If you’re carrying balances from month to month, Walsh says, “in that case, rewards don’t matter at all, and you really want to focus on the fees and the interest rate that you’re going to be paying.” Think about how you manage your finances before choosing the best credit card for you. For your first credit card, you should think about how you manage your money. If you’re really good with your finances, look into a cash back credit card.
But if you’re not, and you won’t be able to pay off your bill at the end of each month, you’ll want to look for a credit card with a low APR (annual percentage rate) on the debt, and cash back credit cards don’t typically offer the lowest APR. “It doesn’t do you much good to earn £10 in rewards and then pay an extra £90 in interest,” Schulman says.
5 ways to use your cash back wisely
With high inflation and high interest rates, budgets are stressed. That being said, people may have less money to put toward their goals, so every dollar (outside of cutting expenses) really helps make progress, Walsh says.
- Redeem it for statement credit. You can choose to redeem your cash back for statement credit, so that it’s going toward paying off your monthly credit card bill.
- Use it to soften the blow of a large upcoming purchase. You can choose to redeem your cash back and use it toward upcoming purchases, like putting down payment on a car, paying off student loans, or buying new, much-needed appliances for your home.
- Deposit the cash into your savings account. You can choose to redeem your cash back and deposit it into your savings account, so you don’t immediately spend it.
At the same time, it’ll earn interest (but at a very low rate).
- Put it in a high interest bearing savings account.
You can choose to redeem your cash back and deposit into a high-yield savings account, so it works for you.
Some high-yield savings accounts are offering a 5% APY (annual percentage yield), as the Federal Reserve raises interest rates.
- Put it in an investment account. You can choose to redeem your cash back and put it in a money market fund, which are typically low-risk investments, with liquidity and market-based yields.
Frequently asked questions
Are cash back credit cards really worth it?
For many, cash back credit cards are worth it because they allow you to take full advantage of your overall spending and provide you with flexibility in how you use those rewards.
Is cash back free money?
If you’re paying your bill on time and in full, you can look at cash back as “free money.” If you’re not, the interest you’ll pay as a penalty will likely outweigh the rewards you’re earning.
