Don't Waste Your Credit Card Cash Back

We are all familiar with the practice of deriving a return on our investments. Equally important is the practice of maximizing returns on our spending. In the United States, we are fortunate to enjoy a system where our credit card companies lure us in to be their customers by offering rewards on our spending. While some cards offer a marginal 1% cash back, others feature rates as high as 2% on all purchases and up to 5% on spending with specific categories of merchants. Combine this practice with a highly competitive market for credit cards, and you have a situation where some consumers can gain substantially from credit card rewards.

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The Potential Impact of Cash Back

There are two things to consider with a cash back credit card.

1. Is Cash Back Worth It? No discussion of cash back rewards is complete without the following caveats. First, credit card rewards are only for credit card users who pay every statement's balance in full and on time. Paying interest, even occasionally, always negates the value of any rewards earned. Paying interest on your purchases is #1 on our list of 8 mistakes made with credit cards. Next, credit card rewards lose all value the moment you find yourself spending more to receive them. Remember, even the best rewards are merely a 2-5% return of your spending, leaving you with the bill for the other 95%-98%.
2. What To Do With All This Cash Back? There are several different ways to account for the cash back. First, there are people who look at cash back rewards as a discount on the price they are paying for the goods and services purchased. In this manner, credit card cash back is like a coupon or some other type of promotional savings and the net expense is seen as the price paid. The other philosophy revolves around seeing this cash back as some sort of income to be saved. Since the IRS considers cash back rewards to be a discount, any money earned is not subject to taxes the way that earnings from work or investments are. Cash back can be used as discretionary spending, or it can be utilized as a contribution to retirement or other savings. For example, a household that uses their 2% cash rewards credit card as a method of payment can earn $600 a year when spending $30,000. If you invested that $600 into a new Roth IRA with an annual return of 5%, this $600 will compound, and the total will grow to over $20,000 over 20 years. In fact, there are several credit cards offered by brokerage firms with this intent in mind. The Fidelity Investments Visa is one of the rare cards that returns 2% cash back that can be deposited directly into the cardholder's brokerage account. Other competing products allow customers to put cash back into savings accounts or a payment towards the principal of a mortgage held by the same bank. In the case of the mortgage contribution, homeowners are essentially receiving a return on their money equal to the interest rate on the loan, although the loss of some of the tax mortgage interest break offsets these savings.

Conclusions

By using your credit card as a means of payment rather than a method of finance, you have the potential to earn substantial cash back rewards. If you have the discipline to invest your credit card's cash back, it can be a relatively small, but important contribution to your retirement savings.