CREDIT CARD SEMINAR PT 2 – WHAT IS THE ACTUAL RATE OF RETURN ON A CARD?
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 the same way again. You will either continue using them with more confidence or you will adopt an entirely new strategy, i.e. applying for and using new cards.
Okay, let’s start with an example. Citi offers a cash back card called the Double Cash. It gives you back 2% (in cash) of every dollar you spend (1% when you make the charge, 1% when you pay it off). So, if you spend $50,000, you will get back $1000 in cold hard cash. No more, no less. Now, if $1000 sounds like chump change to you based on $50,000, great! You want more, and so do I.
As cash back cards go, this one is very hard to beat. 2% everywhere.
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 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 Citi Double Cash has a 2% earning ratio%. 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. In this case, my earning ratio is 1.5%, and my redemption ratio is 1 (with cash back, the redemption ratio is always 1). To put the two together, just multiply the ratios. 1.5% * 1 is still 1.5%.
By comparison, if I spend $25,000 on a Delta Skymiles card, then I get at least 25,000 miles (I will have more if any of that $25,000 was actually spent on Delta purchases since those purchases earn double the miles), but to keep it simple, let’s suppose I earn exactly 25,000 miles. What is my earning ratio? Well, we assume 1 point or mile is worth 1 penny on the earning side. So, we have an earning ratio of 1% here (250/25000). But, what are those miles going to get me? Hopefully you can see that it totally depends on how valuable the ticket is that I get with my miles. If my redemption is for a $400 ticket, then I have a redemption ratio of 1.6 (drop the last two zeros from 25000 and then calculate 400/250). Again, we multiply the earning ratio (1) by the redemption ratio (1.6) to get 1.6. So, in this case, the Skymiles card slightly beats the Quicksilver.
If I keep earning Skymiles with my card 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 2.5 (1500/600). 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 to ask yourself not “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 the Double Cash card I described above, then I’ve done your homework for you (it’s 2% period). 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 this 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! If you enjoyed this post, feel free to like/share this on Facebook and Twitter with your friends. Thanks as always for stopping by.