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What is cash back and how can you maximize credit cards?

Mom was right — money doesn’t grow on trees. But it can grow on cash-back credit cards.

Justin Cupler

Contributing Writer at Tally

January 23, 2020

If you want to maximize your financial harvest, understanding how cash-back credit cards work is critical.

Before diving into the many opportunities associated with these rewards credit cards, you need to know the ins and outs of the system. It can be tricky with all the various categories, caps, interest rates and annual fees, but once you have a firm understanding of how these credit card rewards work, you can use them effectively and start raking in cash.

What is a cash-back credit card?

Cash-back credit cards are just like any other card in your wallet, but they entice you to use them by offering small perks with every swipe. These perks come in the form of points or cash rebates you can use in a number of ways. Some of the most common redemption rewards include:

  • Statement credit

  • Direct deposit to your bank account

  • Cash back toward purchases

  • Gift cards

  • Travel and accommodations

Because there are so many credit card reward programs, understanding cash-back credit cards can sometimes become a little murky. Getting familiar with the three main types of rewards credit cards is a great starting point. They are:

  • Simple cash-back credit cards

  • Category-based cash-back credit cards

  • Tiered cash-back credit cards

Simple cash-back credit cards

The easiest of all the rewards credit cards are the simple cash-back cards. These credit cards offer you a single cash-back rate for all transactions. For example, the Capital One Quicksilver One card offers users 1.5% cash back on all purchases.

With these cards, there is no need to track categories or activate offers — you just swipe and earn. Despite their simplicity, they generally earn you 1-2% cash back, which is higher than the interest rates for most bank accounts.

The drawback is there are no opportunities to earn higher cash-back percentages in select categories, like you can with the other two types we'll discuss below.

Category-based cash-back credit cards

These credit cards offer their rewards in just one category at a time, such as fuel, department stores, grocery stores, and others. Often, category-based cash-back cards rotate their categories, so one month you may get 3% back at grocery stores, but the next month that 3% may shift to gas stations.   

These cards offer large cash-back percentages, so you rack up cash or point balances quickly. Generally, this percentage ends up being 2-3 times the average interest rate on savings accounts.

These credit cards aren’t perfect, though. You may need to use a different card at each store to maximize your rewards. And once you feel like you’ve sorted out the card rotation, they throw a wrench in things by changing their cash-back categories.

Tiered cash-back credit cards

The most complex type, these credit cards use varying reward rates across several categories. For example, the Chase Freedom card may offer 5% bonus cash back at grocery stores one month and 1% cash back on all other purchases. Each month the bonus category changes, but the 1% on all other purchases remains consistent.

Having this type of rewards credit card in your wallet can earn you a lot quickly from the higher cash-back category. Plus, in addition to the bonus category — like the 5% at the grocery store mentioned above — they also offer smaller cash-back opportunities. These could be smaller cash-back amounts in other categories, like department stores or gas stations, or one flat rate on all other purchases. These rates won’t be high, but they give you more opportunities to earn rewards.

There are still downsides to these types of credit cards. First, you’ll have to carefully choose a credit card that offers bonus cash back in the types of stores you shop at most frequently. This is the best way to ensure you maximize the peak rewards. In some cases, you must also remember to log in to your credit card account and activate the bonus offer every time it changes.

The final issue with this type of card is the relative mystery behind categorization. If your American Express card offers 5% cash back at the grocery store this month, you must remember that Walmart likely does not qualify as a grocery store, though many locations have full-size grocery stores inside. Even a Walmart Marketplace, which is a grocery store, might still be classified as a department store by your credit card company.

Using cash back as an investment vehicle

Cash back can earn you more than just a gift card to a trendy restaurant or a trip to Vermont. If you work it the right way, it can also be an investment vehicle.

Most cash-back credit cards offer at least 1% cash back and some reach the 5% mark or higher. The average savings account will earn 0.09% interest at a traditional branch-based bank and 1.377% at an online bank, according to a survey

If you have a card offering a 5% bonus in a category you frequently use, you can take advantage of those rates. Even with a simple cash-back credit card at 1.5%, you’re earning more growth off your own money than you would at the bank.

When used correctly, you will earn money back by spending what you normally would every day. Once you’ve collected a nice sum, you can request a cash payout and put that cash into your IRA or other investment vehicles for further growth. Every little bit helps.

Why credit cards offer cash back

While their commercials may make it look like they offer cash back out of the goodness of their hearts, this is not the case. There are so many credit cards to pick from these days, they’re looking for ways to entice you to apply for and use their card. Getting some extra cash is a great perk to sway your swiping decision.

So how do rewards credit cards make money if they are giving you back extra cash? First, there are the interest rates they charge you. Fortunately, those are avoidable, which we will dive into later.

The real money rolls in from the retailers that accept credit cards and the interchange fees the credit card company charges for processing each transaction. These fees may seem small on the surface, but when compared to the cash-back rates, it’s easy to see how they profit.

The average interchange fee ranges for the key credit card issuers in the industry are as follows:

  • Visa: Between 1.15% (+ 15 cents) and 2.4% (+ 10 cents)

  • Mastercard: Between 1.15% (+ 5 cents) and 2.5% (+ 10 cents)

  • Discover: Between 1.4% (+ 5 cents) and 2.4% (+ 10 cents)

  • American Express: Between 1.43% (+ 10 cents) and 3.15% (+ 10 cents)

So if your cash-back Discover card offers 1% back on all transactions, it still earns on average at least 0.4% of the transaction and the 5 cents from the retailer every time you swipe. Essentially, the retailer is the one funding that $50 Amazon gift card you cashed in your points to get.

Beyond the average transaction fees, credit card companies also charge varying fees for different merchant categories. So while a credit card company may charge a department store a 1.4% interchange fee, it may charge a grocery store 3.5%. These variable fees often align with the higher reward rates on category-based and tiered cash-back credit cards.

How to use cash back effectively

Understanding how cash-back credit cards work is just one part of the equation. You must also know how to use credit card cash back effectively. There are a few critical points to keep in mind to ensure you’re maximizing your benefits.  

Find cash-back credit cards that fit your lifestyle

The first step in the effective use of these rewards credit cards is finding ones that fit your lifestyle.

If you’re a traveling salesperson always on the go, you may rake in the rewards with credit cards featuring fuel-station perks. Every time you fill up your tank, swipe your rewards card and watch that cash add up.

Do you spend a lot on food each month for your family? Get some of that hard-earned money back by using a cash-back credit card with the highest rewards at grocery stores.

If you’re constantly flying across the country or around the world, you may benefit from a credit card that offers high travel rewards like great cash-back rates on hotels, flights and dining out.

And what if you can’t put your finger on one category you spend a large portion of your money on? Then you’re a great candidate for a simple cash-back credit card. Sure, its cash-back rates may not be as high as others, but you make up for that with a consistent rate on every dollar you spend.

Stick to your budget

Earning cash back should never influence how you use your credit card or your spending habits. Instead, only use your credit card just as you would cash or your debit card. In short, stick to your budget so you can pay off your card every single month.

A great way to earn cash back without breaking a sweat or your budget is to use a rewards credit card to pay for day-to-day expenses like utility bills, rent, groceries and streaming services. While you charge these expenses, save your cash and pay off the entire credit card bill by its due date. This lets you enjoy the cash without paying interest.

Immediately paying the entire credit card balance is critical, as one month’s interest can ruin several months of cash-back earnings. Setting up your account to have it automatically deduct your credit card balance on the due date is a great way to avoid any interest or fees.

Stack offers

Credit cards aren’t the only place offering cash-back incentives. There are tons of online shopping portals that offer cash back for shopping at specific retailers. Some of the largest in this segment are TopCashback and Wikibuy.

Simply sign up for one of these sites, find the retailer you’d like to shop at, click on the link provided and shop as you normally would online. Make sure to use that rewards credit card at checkout to double-dip into that cash-back pool. Here’s an example. 

Let’s say you finally saved the amount of cash needed to buy the $1,000 70-inch smart TV you’ve been eyeing at Bob’s Appliances. A quick scan of your favorite cash-back site reveals it’s offering 5% cash back at Bob’s Appliances. On top of that, your rewards card has a 5% bonus for appliances and electronics this month. When you stack these two offers, that $1,000 TV will earn you $100 cash back.

Once the credit card bill comes in the mail, make sure to pay off the $1,000 balance with the cash you saved. You can then roll that cash into an investment or use it for other expenses.

Watch out for caps on credit card rewards

Always read the fine print before committing to a rewards credit card. You may find mention of a cap on the cash back the card can earn. This is especially true in bonus categories where the cash-back rate is high.

For example, Chase Freedom’s credit card terms say you will earn 5% cash back in its quarterly bonus categories but only on the first $1,500 in purchases each year. After that first $1,500, it reverts back to the base 1%. This would equate to a maximum of $75 in bonus cash back per year, plus the unlimited base 1% cash back.

If you frequently max out your rewards program, you may want to consider getting a second cash rewards credit card with the same bonus rewards category.

Consider the annual fee

Another way these credit cards recoup some of their expenses is by charging you an annual fee. You must consider this fee and how much cash back you plan to earn before committing to a credit card.

For example, the Capital One Quicksilver One card offers a strong 1.5% cash back on all purchases but charges a $39 annual fee. To break even with the fee, you must plan to spend at least $2,600 per year on the card.

Responsibility is king

With a firm understanding of what cash back is and how it works, you’re primed to head out and start earning free money. Remember, though, remain true to your budget, never use rewards as an excuse to spend extra cash, and always pay off the bill before you incur any interest.

Now, go get that free cash.