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Free Isn’t Always Better: A Case for the Credit Card Annual Fee

March 4, 2015
Credit Card Basics, Credit Cards, Travel Credit Cards
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We adhere to strict standards of editorial integrity. Some of the products we feature are from our partners. Here’s how we make money.

Humans love free stuff, from conference swag to Costco samples. But what happens when free isn’t the best deal?

This is often the case for credit cards with no annual fees. Sure, it’s free to use those cards year after year, but you could be losing out on significant rewards. Skeptical? Let’s talk about credit card annual fees and when you should consider paying them to come out ahead.

What’s wrong with free?

There’s nothing wrong with free, until you consider its true cost. We choose free because most transactions have an upside and a downside, according to Dan Ariely in his book “Predictably Irrational.” But when something is free, we forget the downside. After all, it’s free and there’s nothing to lose — or so it seems.

When it comes to credit card annual fees, this invisible loss may be significant rewards for the right cardholder. Credit cards with annual fees almost always have higher sign-up bonuses and ongoing rewards than cards without them. Therefore, anyone who can hit the required spending amount for the sign-up bonus will get a larger bonus on the annual fee card than its no-fee counterpart.

After the first year, cardholders who spend the right amount will negate the annual fee and continue to earn higher rewards.

» MORE: 8 Credit card fees and how to avoid them

When should I pay an annual fee?

If you’re building your credit for the first time, you’ll likely start with a secured credit card. Most secured cards come with small annual fees, but they’re worth it to improve your credit. Good credit is necessary for favorable loan terms and insurance rates, and it could help you get the apartment or job you want.

However, the major reason to pay an annual fee is: The rewards you’re getting — less the annual fee — are greater than the rewards you’d get on a card without an annual fee. You may be surprised how easy it is to negate the annual fee with sign-up bonuses and ongoing rewards. Let’s run the numbers.

Will my sign-up bonus negate my average annual fee?

NerdWallet recently published a credit card study with data from 2011-2014. We’ll use those numbers from the study for these calculations.

Annual fee Signup bonus Rewards rate
Cash-back cards $6 $134 1.1%
Points cards $66 $265 1.6%
Miles cards $91 $299 1.1%

Nerd note: These numbers are the average for cash back, points and miles cards. Also, all numbers above are rounded.

The sign-up bonuses negate annual fees several times over. For the cash-back card, the average sign-up bonus pays for the average annual fee more than 22 times. But the average annual fee on cash-back cards is low due to the number of cash-back cards without this fee. Let’s look at the points and miles cards for a better idea of how valuable the sign-up bonus is.

In the case of the points cards, the sign-up bonus pays for the annual fee for four years. For the miles cards, the sign-up bonus covers the annual fee for more than three years. But you’re in this for the long haul. Let’s pretend sign-up bonuses don’t exist. Don’t worry — they’ll come back after this hypothetical.

What about ongoing rewards? 

Using the average rewards rates in the table above, we can determine how much we need to spend each year to counteract the annual fee.

  • For cash back, you need to spend $546 per year or $46 a month.
  • For points, you need to spend $4,125 per year or $344 a month.
  • For miles, you need to spend $8,273 per year or $690 a month.

Nerd note: Many rewards credit cards waive the annual fee for the first year, but let’s be conservative and assume you’re paying the annual fee every year.

The no-annual-fee counterparts of our favorite cards also have rewards, though lower ones. Want to see which is best for you? We have an easy formula for you.

Let’s say you’re thinking about getting our hypothetical points card with an annual fee of $66 and an ongoing rewards rate of 1.6%. However, there’s a similar card with no annual fee and a rewards rate of 1%. If you spend at least $11,000 per year — or $917 a month — you’ll get greater value from the card with the annual fee.

Once you hit $11,000 in annual spending, you’ll not only negate the annual fee, your rewards will also be higher than what you could earn with the no-annual-fee card. Plug in your own numbers to find out where you stand, and add in the value of the sign-up bonus for the first year’s calculation.

Bottom line: Whew, that was a lot of math! Here’s the deal: There’s nothing wrong with free unless the net rewards you could get with an annual fee card outweigh what your no-annual-fee card is giving you. Run your numbers with our formula above to figure out if you should consider changing your stance on annual fees. They may not be so bad after all.


In case you want to run the numbers, here are a couple of the formulas we used …

Calculating the break-even point between ongoing rewards and the annual fee:

  • Cash back: $6 = 0.011x, x = $546
  • Points: $66 = 0.016x, x = $4,125
  • Miles: $91 = 0.011x, x = $8,273

Divide the annual fee by the rewards rate — expressed as a percentage or decimal — to get the amount you need to outspend annually to outweigh the annual fee.

Calculating the break-even point between annual fee and no-annual-fee cards:

No-annual-fee card = 0.01x

Annual-fee card = 0.016x – $66

0.01x = 0.016x – $66, x = $11,000

Divide the annual fee by the difference in rewards rate — the annual fee rewards rate less the no-annual fee rewards rate — to get the amount you need to outspend annually to justify a credit card with an annual fee.

Erin El Issa is a staff writer covering personal finance for NerdWallet. Follow her on Twitter @Erin_Lindsay17 and on Google+.

Image via iStock.