Credit Card Annual Fees and Why They’re Charged
Nobody likes fees.
Nobody likes paying fees. Businesses that charge fees like them because they help offset the costs of doing business and hopefully contribute toward a business’ bottom line.
Many of the fees we pay, we consider justifiable. For example, your health club charges you a fee for the cost of buying and maintaining workout equipment and keeping the building up and running. Your state’s department of motor vehicles charges a fee to process and issue you a driver license. Your homeowner’s association charges fees to maintain common areas of your neighborhood and to prevent your next-door neighbor from painting his house a shade of lavender that could drive your home’s value down.
But when it comes to an annual fee for a credit card, some people feel this particular fee is not justifiable. Well, I’m prepared to make the case that there are actually valid reasons for charging a credit card annual fee.
Two, to be precise.
REASON #1: YOUR CREDIT CARD OFFERS VALUABLE BENEFITS
The main benefit most all credit cards offer is that they provide you with instant credit for making purchases. But all credit cards are not created equal. Some offer perks and benefits that others don’t.
Rewards Credit Cards
A rewards credit card is a prime example of a card that provides valuable benefits above and beyond that of a basic, no-frills credit card. With a rewards card, you earn rewards just for making purchases with that credit card. The rewards you earn can take multiple forms depending on the credit card, including cash back rewards, points, or even airline miles.
Rewards are typically earned as a percentage of purchases made with the credit card or as X points or airline miles awarded for every dollar you spend. So, for example, if you have a rewards credit card that offers two percent cash back rewards, you would earn a $2 rebate—typically redeemable for a statement credit—for every $100 in purchases you make with that card. Or, if you have an airline mileage credit card that rewards one mile for every dollar you spend, spending $100 with that particular card would earn you 100 airline miles redeemable for air travel or other rewards.
If a credit card issuer is giving you cash back rewards or points or miles redeemable for trips, gift cards, or more, doling out those rewards costs them money. That’s where a rewards credit card annual fee comes into play. By charging cardholders an annual fee for the opportunity to earn these rewards, credit card issuers are creating a revenue stream to help them pay for the rewards programs they sponsor.
So, is the annual fee for one of these rewards cards actually worth it? Well, that all depends on you and your spending habits. Say your annual fee on a 2% cash back rewards credit card is $100. In this case, you’d have to earn at least $100 in cash back rewards over the course of the year just to break even on the annual fee. Which means you’d have to spend at least $5,000 on eligible purchases (2% of $5,000 equals $100) annually. Spend any more than $5,000 on eligible purchases with that same cash back rewards card, and that $100 annual fee becomes a good investment because you will have earned more in cash back rewards than you spent for the opportunity to earn those rewards.
Of course, the annual fee is only one fee that may be associated with a rewards credit card. To figure out if the rewards you’re earning are ultimately worth the total cost of a rewards credit card, you also need to figure in any interest and other fees, such as late fees, you’re paying in order to earn those rewards.
But we’ll save that discussion for another day.
Suffice it to say that, in order to determine if an annual fee you’re paying for a rewards credit card is worth it, it should, at the very least, be less than the minimum you expect to earn in rewards over the course of a year with that credit card.
Other Credit Card Benefits
Even credit cards that don’t offer rewards offer perks and benefits that cash simply can’t. For example, many credit cards offer zero fraud liability, which cash does not. They may also offer benefits such as no foreign transaction fees when traveling internationally, purchase protection, free credit score information, supplemental rental car insurance, and more. And the one benefit most all credit cards offer is that they report your payment history to the three major credit bureaus, which can help you to build credit and hopefully develop a healthy credit score. This is something neither cash nor debit cards can do for you.
If you value these additional benefits, then the price of an annual fee for a credit card may well be worth it to you.
REASON #2: YOUR CREDIT CARD ISSUER IS MITIGATING THEIR RISK
If your credit is limited, or isn’t good, and your credit score falls into the middle or lower end of the spectrum, you may discover that most of the credit cards for which you qualify charge an annual fee. Well, there’s a reason for this, and it primarily has to do with the risk you represent to the credit card issuer.
While there’s also risk associated with granting credit to people with positive payment histories and higher credit scores, these folks have something that those with limited or mediocre-to-bad credit do not: a proven track record. A positive history of using and managing credit makes an applicant at least appear to be less risky to a credit card issuer and presents that applicant as a more attractive candidate to receive credit. But if you have little or no history with using credit, or your history demonstrates a lack of commitment to making consistent on-time payments, you may not qualify for a credit card with no annual fee.
Annual fees charged by issuers that provide credit cards to people with little or less-than-ideal credit help these issuers lessen their risk. They are anticipating having more late or missed payments and higher default rates than they would serving people with higher credit scores. The annual fees help to offset the higher cost of serving customers without proven track records of using and managing credit responsibly.
When you think about it, it’s not dissimilar to a bank or finance company charging a borrower with so-so credit a higher rate of interest and less-favorable terms on an auto or home loan than they would another borrower with great credit. Only, in their case, there is an actual piece of collateral—a car or home—that can be repossessed should the borrower fall behind in payments or default on the loan. While credit card issuers may also charge higher interest rates to those with lower credit scores, they don’t have the option of repossessing every item bought with their card from cardholders who miss payments or stop paying altogether.
Annual fees help credit card issuers to mitigate risks and lower their cost of doing business with a riskier clientele.
While I’m sure I haven’t convinced you to love credit card annual fees (never my intention), hopefully you at least understand why they exist and that, yes, there are valid reasons for their existence.
If you have good credit, chances are you’ll be able to find a credit card out there that meets your needs and doesn’t charge an annual fee. Or at least one that offers benefits that outweigh the cost of the card’s annual fee.
If your credit isn’t great, the good news is that, by using a credit card with an annual fee responsibly—as in making consistent on-time payments every month and effectively managing your credit—you’ll hopefully soon be in a position to qualify for a credit card with no annual fee. Or, again, one offering benefits you feel are well worth the card’s annual fee.
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