Credit Card Seminar Pt 2 – What is the Actual Rate of Return on a Card?

Ready to move on?  Hopefully you have already read my earlier post How I Got $16,000 In Airfare for $300.

Again, here is the complete list of articles in the series:

  1. Getting Your Credit In Order
  2. What Is the Actual Rate of Return on a Card?
  3. The Different Types of Credit Cards: Cash Back, Fixed Value, and Flexible Point
  4. Why Signup Bonuses Are the Key to Free Travel
  5. What Are the Right Cards For Your Desired Trip?
  6. What Are App-o-Ramas?

Today we will really start getting a better understanding of just how much you are getting back from your rewards cards.  I think you will be genuinely shocked by some of what you read below…

1% cash back.  1.5% cash back.  2 miles on every purchase.  5x points on dining.  Sound familiar?  Sound confusing?  This is what I’m going to try to make crystal clear for you, and once you get it, you’ll never look at your existing cards again.  You will either continue using them with more confidence or you will adopt an entirely new strategy, i.e. apply for and begin using new cards.

Okay, let’s start with an example.  Capital One offers a cash back card called the Quicksilver.  It simply gives you back 1.5% (in cash) of every dollar you spend.  So, if you spend $10,000, you will get back $150 in cold hard cash.  No more, no less.  Now, if $150 sounds like chump change to you based on $10,000, great!  You want more, and so do I.

My favorite one card fits all card. You’ll be hearing more about it through this series

Now, by comparison, Barclay’s offers the Arrival card.  It also offers a fixed rate of return, but this card offers 2.2% back on every purchase… but only if you use it on travel purchases.  Otherwise, it’s a 1.1% rate of return.  So, that $10,000 we just talked about would yield $220 in travel rewards but only $110 in cash.  So at this point, you’re probably thinking one of two things: “I want cash because I like cash” or “I want travel because I get more in value.”  If you are of the first mindset, brace yourself.  You’ll never consistently get more than 1.5 to 2 percent back in cash, and even 2% is hard to get consistently.  But if you are wanting your rewards to be in the form of travel, I’ve got great news: beating 2% is very doable.  By the way, if you decide that cash is your thing and that I can’t sway you toward travel rewards, no hard feelings.  And I’ll even tell you the two flat out hands down best cash back reward cards: the Fidelity Rewards American Express and the Citi Double Cash Card.  They both offer 2% cash back with a bit of a twist.  The Fidelity card earns 2% on everything you buy, but that money must go into a Fidelity account.  The Citi card offers 1% when you make the purchase and another 1% when you pay for it.  In case you are wondering why credit card issuers can offer more value in travel, it’s simple.  They don’t want to give away cash.  Miles and points, though?  They buy them from the airlines and hotel chains, and they get them at a considerable discount.

Now, I used those cards above because they are very easy to understand.  Barclay’s issues a lot of Arrival cards for the same reason: they are simple.  No special categories, global acceptance of the card by merchants, and a steady rate of return.  But, there are other cards which may do more for you in certain situations.

Let’s consider an airline credit card, such as the ones offered by Delta, United, and American.  Their credit cards typically earn miles as follows: earn 2 miles per dollar spent on that airline (tickets, bag fees, etc.) and earn 1 mile on all other purchases.  For simplicity, think of a mile as a penny.  So, 1 mile really is 1 percent back, 2 miles is 2 percent back, etc.  The most common use of these miles is on economy class domestic airfare, and the almost universal rule of thumb is: 25,000 miles gets you a free round trip ticket.  So, what is your rate of return here?  Well, it depends on where you fly.  For example, I recently booked a flight using Delta Skymiles to go from Atlanta to Newark.  The flight would have cost me $320 in cash, but I got it for 25,000 miles.  Suppose, to make it easy to follow, I had used a Delta card to accumulate those 25,000 miles by spending $25,000 in non-Delta purchases.  My rate of return on my purchases would be $320 / 25,000, or 1.28 percent.  Compared to the Barclay’s Arrival (with its flat 2.2%), this stinks.  But let’s consider another example, and maybe this will ring a bell if you read the article I wrote a couple of days ago, How I Got $16,000 In Airfare For $300.  If you recall, I said that it took me 200,000 United miles to get 2 business class tickets worth over $16,000.  Now, I can tell you that I did not spend $200,000 to earn those miles, but what if I had?  I would have gotten $16,000 / $200,000, or 8% in return.  8 percent people!  That is a staggering rate of return, fully 4x what Capital One is offering.

The Barclay’s Arrival is a better card for domestic coach flights, but the United Explorer card was vital in my business class flight to Greece. Why? Its redemption ratio was much higher on international business class. Keep reading below and you’ll see what I mean.

Okay, now that I have hopefully gotten your attention with that last nugget, I want to take a minute to explain two different terms/concepts that people often confuse, and they are the entire point of this article.  This confusion causes a lot of people to leave a lot of money on the table in terms of what they get back from the money they spend.  The two terms are: earning ratio and redemption ratio.  Almost everyone focuses on the earning ratio because it is so easy to understand.  They never focus on the redemption ratio, which is where the real opportunities lie.

The earning ratio is what you hear in every commercial.  The Quicksilver’s earning ratio is 1.5%.  The Arrival earning ratio is 2.2%.  The Chase Sapphire Preferred earning ratio depends on the category: 2% for dining and travel, 1% for everything else.  We can all easily understand this concept.  Multiply your spent dollars by the percent, and that’s what you get back as a reward.  Nothing to it.  BUT WHAT CAN YOU GET WITH THOSE REWARDS?  That is what I mean by redemption ratio.  The card issuer has just put a reward (either cash, points, or miles) in your pocket, but what can you get with it?  If that question confuses you, you are not alone.  Let’s look at some examples to clear it up:

If I spend $10,000 on the Quicksilver card, then it’s simple.  With its 1.5% percent cash back, I get $150 in cash, and cash is cash, so my $150 reward is worth exactly that.  Since my reward equals my redemption value ($150 in rewards yields $150 in redemption), then I consider the redemption ratio to be 1:1 (i.e. 1 dollar in rewards yields 1 dollar in redemption value).

If I spend the same $10,000 on the Barclay’s Arrival card, then I will get 2.2% percent in travel rewards. So, I have $220 in travel.  Since this card’s rewards are fixed value (always 2.2%), that $220 is worth exactly that much.  Again, my redemption ratio is 1:1.  Just to drive home the point, the Arrival card beats the Quicksilver on its earning ratio (2.2% to 1.5%), but they are even in terms of the redemption ratio.

Now, if I spend the same $10,000 on a Delta Skymiles card, then I get at least 10,000 miles (I will have more if any of that $10,000 was actually spent on Delta purchases since those purchases earn double the miles), but to keep it simple, let’s suppose I earn exactly 10,000 miles.  What are those miles going to get me?  Until I hit 25,000 miles, not much, since 25,000 miles is required for a free flight (note: I’m not getting into one-way redemptions at half price as it might confuse some people).  But suppose I continue using the card until I spend $25,000 and get 25,000 miles.  What is my redemption ratio now?  Hopefully you can see that it totally depends on how valuable the ticket is that I get with my miles.  In the points/miles world, we consider a mile to have a base value of one penny.  So, if my redemption ticket is for a $250 ticket, then I once again have a redemption ratio of 1:1 (25,000 miles have a base value of $250), but suppose the ticket is worth $500.  Then I’ve doubled my redemption ratio.  If I keep earning miles and move into international trips, then I may encounter a case where 60,000 miles gets me a ticket worth $1500.  Now my redemption ratio is 1: 2.5, i.e. 1 mile is worth 2.5 dollars.  When I move into business class tickets on international flights (such as my trip to Greece), that’s when the redemption ratios go through the roof.

So, what is the lesson here?  Every card out there has its own earning ratio and its own redemption ratio.  The earning ratios are typically very predictable while the redemption ratios can either be constant or wildly variable. Your homework from this article is not to ask yourself “what’s in my wallet” but “what are the earning and redemption ratios from the cards in my wallet?”  If you don’t know, then there is a good chance you are not getting as much as you can.  For example, if you are carrying a Capital One card like I described above, then I’ve done your homework for you.  If you are using an airline or hotel card, ask yourself just what you got out of your miles/points?

So what is next in the series?  Well, let’s just say that I personally am not a one card for every purchase kind of guy.  I am constantly changing which cards are in my wallet, but I do so with a specific plan in mind, e.g. “I need more Starwood points” or “I need points that can be used on whatever travel I want.”  I’ll cover these different kinds of cards in the next article, I promise, and you will be blown away by just how many different strategies are possible using them.  Until then, do your homework!

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