Cash back credit cards: How do they work?

What could be easier than getting a little money back on the things you buy every day? That’s how cash back credit cards work and what makes them appealing to some consumers.

Cash back cards come in a variety of flavors — bonus categories, tiered rewards and flat-rate cash back — but they all pay you back. Flat-rate cash back cards are ideal for the “set it and forget it” crowd, but bonus category and tiered rewards cards can earn you more rewards if you’re willing to put in a little effort to maximize your cash back in select spending categories.

How cash back cards work

So, how do all of these cash back cards work? It’s simple: Cash back is essentially a rebate of a percentage of the purchases you make on the card. With flat-rate cash back credit cards, every purchase earns the same percentage cash back, while category bonus cards and tiered bonus cards require different types of spending to earn more cash back.

Card issuers can afford to pay cash back because merchants pay an interchange fee on each transaction. “When you pay a merchant $100 with a credit card, the merchant only receives about $97,” says Daniel Mahoney, a certified financial planner in Atlanta.

For example, a TV that costs $700 would net you $14 with a 2% cash back card. The merchant, meanwhile, paid a transaction fee of around $21 when you paid with your credit card.

“Rewards or rebates may also be funded by deals between the credit card issuer and specific merchants,” said Mahoney. An example of this is cash back you earn through card-linked offers.

How do card issuers know what types of spending qualify for which percentage of cash back? Merchant category codes are four-digit numbers denoting a business type, such as a gas station or grocery store. Credit card networks use these codes to categorize and track purchases.

How to earn cash back

There are three main types of cash back credit cards: Category bonus cash back cards, which offer a high cash back rate in spending categories that change throughout the year; tiered rewards cash back cards, which offer consistent cash back in specific categories of spending; and flat-rate cash back cards, which get you cash back at the same rate on all purchases.

Category bonus cash back cards

Category bonus cash back cards offer the lure of 5 percent cash back on revolving spending categories. These categories are typically set by the issuer every quarter and are usually released a few months before the new quarter starts. Five percent back can be a nice haul if you’re able to max out the spending categories each quarter, but it takes a bit of work.

You have to register for the bonus categories every three months, and spending in the categories is capped at a set amount each quarter (typically $1,500 in purchases). Since any purchase not in the bonus category earns 1 percent, you may not be getting the average return you think you are.

Tiered rewards cash back cards

Like category bonus cards, tiered rewards cards offer more cash back in specific spending categories, but you should consider which card to use with each purchase to maximize your earnings.

Restaurants, gas stations, grocery stores, select travel and transit, select streaming services, drugstores, home improvement stores, fitness clubs, and live entertainment are just a few of the categories in which you can earn that 5 percent.

Flat-rate cash back cards

With simple cash back cards, also called flat-rate cash back cards, you earn a flat percentage with every purchase. There’s no need to track and activate bonus categories. You earn the same cash back on every purchase.

Bottom line

Whether you opt for a flat-rate, tiered rewards or category bonus cash back card, you can enjoy earning cash back on all (or nearly all) of your purchases, often with minimal effort.

You may be surprised at just how much 1 percent or more cash back adds up to at the end of each month. Just be sure to take a close look at your spending habits and each issuer’s terms to determine if the cash back card you’re considering is a good fit for you.