June 19, 2008

Credit card rewards #1 - choosing miles rewards versus cash back

I use credit cards for all the purchases I can in order to take advantage of the cash back rebates. But I pay off the balance every month.

Before I discuss the topic of credit card rewards, I want to make this clear: It is only worth looking at credit card rebates if you pay off the balance of the credit card every month. If you carry a balance on your card then you should instead be focusing on reducing your credit card debt first and avoid additional credit card use.

Right now I'm using a Citibank dividend platinum card that gives me 1% cash back on most purchases and 2% on gas, grocery, drug store, convenience store, cable and utility purchases. Its a pretty decent reward and I like Citibank as a company overall. One drawback is their maximum reward is $300 a year and I'm going to exceed that this year primarily due to a large one time only expenditure that I put on the card. So I'm looking around for other options.

I've seen some other options for cards that I'm looking into. There are 3 main categories of rewards cards: cash rewards, miles rewards and points rewards. Cash rewards are fairly self explanatory they give you cash rebate on your purchases, usually 1% or more. Miles rewards are tied to airlines miles points and they give you airline miles for your credit card purchases, usually 1 mile per $1 spent. The Points rewards fall into other promotional points programs like hotel frequent stay programs or simple points for items rewards programs.

Generally I'd say that the cash rewards are the most flexible and easiest to use. You typically just get a cash rebate on your purchases. You're not forced to use the reward on anything in particular and aren't forced to work under someone else's rules or schedules. With miles or points systems you might be able to get a higher return on your rewards but you are required to use the service that the card is attached to.

How to determine if you should go with an airline miles card or not
To determine if a miles or points system might be more beneficial for you look at the program details and determine if you will be able to get good use out of the rewards offered.

Would you be able to use the miles? (yes or no) People often assume that they'd be able to make use of frequent flier miles, but with the restrictions and blackout dates on some programs it can be hard to ever use your miles. So the first step in deciding if an airline miles card is a good choice for you, you should make sure you'd be able to use the rewards. To do this, consider what places you go and when and what airlines typically fly those routes. For example if you are considering a miles card tied to a specific airline, check the airlines website and see if you'd be able to redeem their frequent flier miles for a trip to a location you would go at a day/ time that you'd travel. For example if you fly from Texas to Illinois every Christmas to be with your family on United airlines then check the United website to see if you'd be able to redeem their frequent flier miles for a Christmas trip. If the answer to whether or not you can make good use of the miles is yes then go on to figure the rate of rewards. Of course if you can't use the miles then theres not much sense in getting such a card.

What is the effective dollar value of the rewards? If you redeem frequent flier miles then you're saving the cost of a ticket. The ticket prices vary but you can estimate general costs. To do this I'd simply do a search on a site like Kayak.com or Orbitz.com and see what typical round trip fares will run you. You can also check Farecast.com which has data on price trends over time. For the example above a Christmas time trip from Austin Texas to Chicago Illinois ran $402 a seat if purchased well in advance. You can then use this as a ballpark figure.

What is the % return of the travel rewards from credit card purchases? To determine this figure the cost of the ticket you're saving divided by the total credit card purchases you'd have to make in order to obtain the miles for it. For example if you get 1 mile per $1 and your round trip ticket from Austin to Chicago costs 25,000 miles then it would take $25000 of credit card purchases to get that reward. The value of the reward is $402 so you are getting $402 reward / $25000 purchases which equates to a 1.6% effective return rate.

(If the card has no fee then skip this. ) If theres an annual fee, then figure what is your annual % return rate less the fee? With airline miles cards it is not uncommon for them to have an annual fee. To determine your annual rewards rate consider your annual rate on return less the fee. Starting with the rate we just figured above multiply that % rate by your annual expected credit card purchases then subtract the annual fee. So for example if you spend $12000 a year on your card and we figured the 1.26% rate then your annual return is $192 but if there is an annual fee of $65 then our total annual return less fee is $192 - $65 or $127. Note that this is marginally more than the $120 we would earn in cash with a straight 1% cash return card.

Make the decision is it really worth it or not to go with miles?
Now that you know how much the card will return you in equivalent cash value you have to decide if its really worth it to have your rewards in the form of airline miles or if cash would be better. If you frequently travel and miles are easy enough to use then a higher return on the miles can make it really worth your while. But if the effective return from miles less a fee for the card isn't that much more than just getting a cash return then airlines miles are probably not the best choice. For the example above I figured the effective rate at $127 a year for airline miles card based on a specific usage but this is just $7 a year more than a flat 1% cash return for the same amount of credit card purchases. In my opinion that $7 more return is not worth the loss of flexibility that you'd get with cash so I'd stick with the straight cash back refund option in that example situation.

To summarize, the decision process is:

  1. Can you use the service? yes or no.
  2. What is the value of the service? Figure value in terms of $
  3. How much credit card purchases would you need to spend to get the service?
  4. Divide the value of the service by the required purchases to find the reward % rate.
  5. Lastly, find you real annual return by subtracting any credit card fees.

To evaluate points rewards system you can do a similar calculation. Simply figure out if the % return rate is in terms of value of the item or services that you can obtain with the rewards per dollar spent on the credit card. So the same methodology can be used for Hilton hotel nights or free Sony electronics.

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