Cash Back
When I was 18, my dad took me to the bank to get my first credit card. I had a conversation with the bank teller that went something like this:
Bank teller: This card gives 1% cash back.
Me: What does that mean?
Bank teller: It means when you spend money with the card, you get 1% cash back.
Me: But what does cash back mean, though?
Bank teller: It means you get cash back.
Me: …
The bank teller communicated poorly, and also I did not do a good job at articulating which part I was confused about. If I were that bank teller, here is what I would say to my 18-year old self:
I understand you to be asking two questions.
- As you understand it, “cash” means “paper money”. And you are wondering how it is logistically possible for the bank to give you paper money when you use your credit card. Is a courier going to run to the store you’re at and deliver the cash? Surely that’s ridiculous?
- This deal makes it sound like the bank is giving you free money. Why would they give you free money? How is that profitable for them?
The answer to the first question is that no, they are not going to give you paper money. They are going to deposit the 1% cash back into your bank account.
The answer to the second question: it is indeed profitable for them to pay you 1% of the value of every purchase you make. The reason is that the credit card company charges a fee to businesses (typically around 3%) whenever you buy something at that business. Most companies eat this cost by charging the same price to both cash and credit card users, which means effectively you get a discount by paying with a credit card. Businesses are willing to do this because they can attract more customers if they accept credit cards.
Credit card companies then take a portion of that ~3% fee and give some of it back to you as “cash back”. (Some cards also give you perks, like discounts on arline tickets.) You might ask, instead of giving you 1% cash back, why don’t they just make the prices be 1% lower? The answer is that it is a dumb psychological trick to make people think they’re getting a better deal. At least that’s part of the answer, it could also be because of logistical issues with prices being set by businesses vs. credit card companies in which businesses always pay the same rate to credit card companies, but credit card companies give better benefits to people who are a lower credit risk.
But it is genuinely 1% cheaper to buy things with a credit card than with cash, assuming you pay off your card balance each month before accruing any interest.
Also, 1% cash back isn’t even a good perk. You can get 2% cash back with the Citi Double Cash card. I’m guessing your credit rating isn’t good enough for that card yet, but you’re gonna apply for it in a few years. There are also lots of other cards with fancy perks, but you’re not gonna care about those perks so you should just go for the 2% cash back.