Mellody's Math: The Real Price of Credit Card Rewards

Sept. 1, 2004 -- Credit cards that earn rewards with every purchase are the hottest craze in the credit card industry today.

According to CardWeb.com, approximately 40 percent of all bank credit cards have a rewards program affiliated with them. Given the sheer volume of the offers — in the hundred millions, coupled with the accompanying fine print — it is often difficult to determine which programs are actually "rewarding." In fact, according to The Nilson Report, a payment systems newsletter, only 30 percent of credit card users have a rewards card with no annual fee. That said, how can you find the golden egg of the credit card industry?

Do Your Research

The key to maximizing a rewards card is to read the fine print before signing up. While many cards offer an interest rate of zero percent for the first six months, it is important to find out what happens after this period has elapsed, as the rates could increase dramatically.

You also should avoid those cards with an annual fee as well as those which require a high balance to actually earn any rewards. Additionally, find out how you redeem your rewards to ensure that the process is hassle-free with no additional costs attached, and be sure to select a rewards card that actually suits your lifestyle and will be of use to you and your family.

Most importantly, regardless of the card you choose, only spend what you can afford to pay off each month. It does not pay to earn a free airline ticket or $50 cash back if the end result means you are in debt.

Cash Is King … Or Is It?

Since Discover Card initiated the first cash-back rewards program in 1986, the practice has grown significantly. Specifically, approximately 1 billion, or 25 percent of all credit card solicitations in 2003 were for cash-back rewards, up from 700 million in 2002, according to CardWeb.com.

While cash-back offers sound enticing, under the surface often lies a host of disclaimers, restrictions and requirements. The most common red flags to watch for are the following:

A limit on the reward. Most rebate cards have a limit on how much cash you can earn, with most offering 0.85 to 2 percent cash back on purchases. For example, the Fifth Third Bank MasterCard rewards 1 percent of each dollar (a penny) that a cardholder spends, up to $500 per year — meaning you would have to spend $50,000 to receive $500 cash back.

A tiered formula. Many cards have a tiered formula — the more you spend, the more cash back you earn. With the Discover Card, you earn 0.25 percent for the first $1,500 you charge per year, which is equal to $3.75. However, the reward increases to 0.50 percent for charges above $1,500, but below $3,000, and moves up to 1 percent for charges over $3,000.

The bigger the balance, the bigger the "reward." Many cash-back cards require users to carry a balance, and unfortunately, for the 48 percent of Americans who carry a balance on their credit cards, the lure of getting more money back can be a dangerous incentive to spend more than they can afford. For example, to get 5 percent cash back with an American Express card, you must carry a balance.

Rewards With a Twist

In an effort to entice new customers to sign up for rewards cards, many card companies are moving away from common rewards such as airline miles and cash, instead offering customers unique experiences and products in exchange for their spending.

Sony, working with Bank One, offers the Sony Card. Points, which rack up with each dollar spent, can be redeemed for Sony merchandise. Cardholders, both new and current, were also offered the opportunity to attend a John Mayer concert in Bryant Park in New York City earlier this summer. The price of admission? A Sony credit card in hand or a completed application.

Newcomer Stratus Rewards entered the rewards marketplace with a Visa card issued by U.S. Bank this spring. Stratus Rewards bills itself as an invitation-only lifestyle club offering a globally accepted credit card. Members earn points with every purchase which can be redeemed on their own or pooled with other members' points to obtain an even bigger reward, such as travel on a private jet.

Other unique experiences that can be achieved by earning a certain number of points include a yoga session with Gwyneth Paltrow or a consultation with entertaining expert Colin Cowie. Alternatively, members can choose to use their points to make charitable donations. The catch with Stratus Rewards is that membership costs $1,500 per year for the primary cardholder and $500 for each secondary cardholder — a very hefty fee, despite the allure of the rewards.

Relevant Rewards — Real Help

Those who are not interested in concert tickets or a stay at a fancy hotel can sign up for a myriad of cards offering practical incentives. For example, new to the credit card market are cards that earn points toward your mortgage. Citi Home Mastercard and GMAC Mortgage MasterCard are two players in this field.

With Citi Home Mastercard, you can earn 1 percent on your purchases which can be paid directly to your mortgage principal, regardless of your lender. There is no annual fee and no limit on how much you can earn. To make things easy, Citi will automatically apply the rebate amount to your mortgage each year.

GMAC Mortgage MasterCard, issued by MBNA, allows cardholders to earn one point for every dollar spent, and once you reach 2,500 points, $25 is automatically credited to your mortgage. Although there is no annual fee and no annual limit on how many points can be earned, the rewards are only applicable for GMAC mortgage products.

With gasoline prices as expensive as they are, credit cards with a gas rebate reward are ever more appealing. According to an analysis by CardWeb.com, a consumer could save as much as $300 a year on gasoline by choosing to pay with a credit card at the pump. The gas rebate cards come in every station — from Citgo to Shell — and offer between 1 percent and 10 percent back on gasoline purchases.

Some cards only offer the savings at specific stations, while others allow a user to fill-up anywhere. Additionally, all of the major rewards cards in this space do not charge an annual fee.

The Web site www.cardratings.com helps consumers compare various cards in one place.

Charging for Charity

In addition to cards that reward you and your family for spending, there are many affinity cards that reward others for your purchases. Specifically, not-for-profits are increasingly linking with financial institutions to receive a donation every time a given consumer uses their credit card.

According to Bankrate.com, the average contribution is .05 percent, or half a penny, for every dollar spent. For example, if you charge $1,000, the financial institution behind your Visa or MasterCard will contribute $5 to the charity linked to the card.

While the individual donation is fairly insignificant, the aggregate donations (those from other card users linked to the same charity) can definitely add up. One final point — it is important to keep in mind contributions made via an affinity card are not tax deductible.

Retirement Rewards

Rewards cards are also targeting those who are concerned with saving for retirement. Specifically, credit cards such as MBNA's Fidelity Investments card and MBNA's NestEggz.com card allow you to direct cash rewards to a retirement or investment account.

The Fidelity Investment Rewards Mastercard allows you to earn 1.5 percent on your purchases which can be credited to your Fidelity account (both taxable and non-taxable accounts, such as IRAS, are eligible). There is no annual fee for this card, but you can only earn $1,500 per year on your purchases (you would have to spend $100,000 to reach this limit).

With NestEggz, you can earn a 1 percent rebate on every purchase, and when you shop within the NestEggz merchant network your rebates are even higher, ranging from 2 percent to 20 percent for each purchase. The money you earn can then be directly deposited into your retirement account (Traditional, Roth or Rollover IRA) — balances of $25 or more are deposited monthly. While there is no annual fee and no annual maximum on the amount you can earn, your retirement account must be enrolled in the NestEggz program to be eligible for the rebates.

If you choose to sign up for one of these retirement rewards credit cards, it is critically important to keep track of the money being credited to your account as well as the money you deposit directly to ensure you do not exceed maximum allowable contribution to an IRA account ($3,000 in 2004).

Brokerage Firms

This past spring, Merrill Lynch entered the credit card business with the Merrill+ Visa, joining another brokerage firm, Smith Barney, which offers a Platinum Select Mastercard through Citibank. There is no annual fee for Merrill+ Visa, and the current interest rate is 5.9 percent.

Cardholders earn one point for every dollar charged and points are redeemable for airline flights, hotel stays and more. The benefits are tiered according to the amount spent with "+Benefits" available to all cardholders, "+2 Benefits" for those who spend $20,000 or more each year and "+3 Benefits" for those charging $50,000 or more each year. The Merrill+ Visa is primarily targeted toward current Merrill clients, but others can apply for it too.

Notable Statistics

Thirty-six percent of consumers have had a rewards card for at least five years, but half of them have never actually cashed in their points or miles for a reward, according to Maritz Loyalty Marketing.

Survey research from TNS Financial Services suggest that only 17 percent of high net worth individuals find exclusive access and preferred seating for events to be "very attractive," while 47 percent rate it "not attractive."

One air mile typically carries a value of 2.5 percent of the amount charged.

Mellody Hobson, president of Ariel Capital Management (arielmutualfunds.com) in Chicago, is Good Morning America's personal finance expert. Ariel associates Matthew Yale and Aimee Daley contributed to this report.