Credit Card Annual Fees and Why They’re Charged

Introduction

Nobody really likes paying fees. We could even say that many consumers would love to do away with fees altogether — but that doesn’t really make sense in the grand scheme of things. We need to look at both sides of the coin (the party paying the fee and the party charging the fee).

So why do businesses charge fees? Because fees bring in income, and that money helps to do a couple of things:

• Offset the costs of doing business

• Contribute toward their bottom line

If you think about it, you can probably come up with a lot of fees that you consider justifiable. Like your health club, which charges a membership fee to cover the cost of buying and maintaining workout equipment in a modern building with a large parking lot. Or the DMV, which charges a fee to process and issue you a driver’s license. Or your homeowner’s association, which charges a fee to maintain common areas of your neighborhood and enforce rules that may help improve your home’s value.

But some people draw the line at credit card annual fees, saying that particular fee is not justifiable. So let’s examine what they are, and why they’re charged, which might provide a clearer understanding of these fees.

What Are Annual Fees?

Annual fees are actually named extremely clearly. They’re fees charged annually, meaning once a year (technically). Although, there’s some nuance here that we’ll get to in a second.

But first, the main thing to understand is that some credit cards charge what’s essentially a membership fee to own that card. As long as you want to keep the card, whether you use it or not, you’ll typically be charged the agreed-upon annual fee for the privilege.

These fees vary greatly by the creditor, the card, and the card’s benefits. They can also vary by the consumer and their credit scores. But it’s not unusual to see a fee in the range of $40 to $100 per year, and sometimes hundreds of dollars for a premium card.

When Are Annual Fees Charged?

This seems like a simple answer — annual fees, by definition, should be charged once a year. And many cards do take that approach. But here’s where that nuance comes in.

Some credit cards break up an annual fee into monthly charges to make them more manageable. It’s still technically an annual fee, but you don’t pay the whole thing at one time. For example, an annual fee of $75 could be broken up into twelve monthly charges of $6.25 per month on your credit card statement.

This approach creates a few benefits for the cardmember:

• Regular charges keep the card active so it doesn’t get closed for inactivity.

• Smaller charges are easier to deal with and pay in full.

• Paying off those small charges each month contributes to positive payment history, which is one of the most important factors in credit score calculation.

Why Do Creditors Charge Annual Fees?

OK, so now we’re getting into the meat of the topic. Why do creditors charge annual fees that simply allow you to have that credit card? Don’t they make money off other things, like charging you interest and other fees?

Well, from the larger operational perspective, creditors do make some money off merchant fees and investment potential. But they don’t necessarily make income from the actual cardmembers receiving the service.

If you carry a balance on your credit card then yes, you’ll likely be paying interest to the creditor. However, if you pay off your full balance each and every month, and you have a grace period on your credit card, you might not ever be charged interest.

And other credit card fees do exist, like late fees, foreign transaction fees, cash advance fees, ATM fees, credit limit increase fees, and statement fees for printed copies. But if you always pay on time, don’t travel, don’t request advances or increases, and access your statements online, chances are you can avoid most or all of those fees.

Annual fees are one income source that creditors can rely on, and they usually give you something of value in exchange for that fee.

How Do Annual Fees Offset Valuable Benefits?

One of a credit card’s biggest benefits is the instant credit it offers you for making purchases. You can buy something now, and pay it off later — either as one lump sum or a bit at a time.

But not all credit cards are created equal, and many of them offer unique or valuable perks and benefits beyond just purchasing power.

Credit card rewards

A good portion of modern credit cards offer rewards that you can earn on purchases — in fact, 70% of consumer credit cards listed in the Consumer Financial Protection Bureau (CFPB) database have rewards programs, according to the Consumer Bankers Association.

As opposed to your basic no-frills card, a rewards card offers perks like cash back rewards, points or travel miles. You might be able to redeem your rewards as a statement credit, bank deposit or choice of gift cards. Or it may be possible to turn them into merchandise or air travel, depending on the card’s rewards structure.

Rewards are typically earned as a percentage of purchases made with the credit card, or a certain number of points or miles for every dollar you spend. And that can be either for all purchases or specific categories.

So, for example, if you have a card that offers 2% cash back rewards on all purchases, you would earn a $2 rebate for every $100 spent on that card. If you have a travel credit card that rewards you with one point for every dollar spent on flights, gas and car rentals, an eligible $100 car rental on that card would earn 100 points to redeem for travel or other rewards.

Of course, if a credit card issuer is giving you cash back rewards, points or miles redeemable for trips, merchandise, gift cards, or statement credits, that costs them money. Charging cardmembers an annual fee creates a revenue stream to help fund the rewards programs.

But is the annual fee actually worth it for one of these rewards cards? Well, that depends on you and your spending habits. Let’s say your annual fee on that 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 a year just to break even on the annual fee.

That means you’d have to spend at least $5,000 on eligible purchases each year (2% of $5,000 equals $100). If you spend more than $5,000, that $100 annual fee could become a good investment because you’ll earn more back than you spent for the opportunity to earn those rewards.

Of course, if you’re carrying a balance or incurring other fees, those charges can also eat into your total haul. But generally speaking, and in a vacuum, an annual fee can be well worth the cost if it’s less than what you expect to earn back that year.

Other credit card benefits

Now we’ll go beyond the surface-level calculation. Even credit cards that don’t offer rewards will typically come with perks and benefits that cash doesn’t.

For example, many credit cards offer zero fraud liability, which protects you from unauthorized charges. They may also have benefits like purchase protection, free credit score information, supplemental rental car insurance, no foreign transaction fees when traveling internationally, airport lounge access, and more.

And the one huge benefit that nearly all credit cards offer is the opportunity to build credit and improve your credit score. Most major creditors report your payment history to the three major credit bureaus, and as long as that history is good — paying on time and keeping balances low or paid off — your score will likely get better over time. This is something cash and debit cards can’t do.

How Do Annual Fees Help Creditors Mitigate Risk?

You might appreciate the opportunity to build credit, but we again need to consider the other side of that coin. If you’re at the point where your credit score could use a good boost, think about how you got there.

Maybe you missed some payments on a past credit card. Maybe you even defaulted altogether and your account was sold to a collections agency. Or maybe you had to go so far as to declare bankruptcy. As a result of any of these things, your credit score could take a dive. And at the same time, your previous creditors probably lost money on your debt misadventures.

When you’re trying to start over and rebuild your credit, you may find it hard to get approved for another credit card. Creditors are usually “once bitten, twice shy,” as the saying goes.

But let’s say one card issuer decides to take a chance on you. It’s a big risk because you’ve proven you can be unreliable with credit, but they offer you a credit rebuilding product to reestablish yourself. Like most credit cards for consumers with lower credit scores, that rebuilding card likely comes with an annual fee.

This fee helps hedge the bet in two ways.

• If you’ve paid an annual fee, you’re less likely to walk away from that credit line.

• If you do end up defaulting, at least the creditor got that annual fee to help cover their losses.

These possibilities aren’t as big a concern for people with higher credit scores because they have a proven track record of paying on time. As a result, they’re more likely to have access to credit cards with no annual fees.

By the same token, a bank or finance company dealing with home or auto loans will typically offer a lower interest rate and more favorable terms to a borrower in a higher credit score range. A consumer with poor to fair credit may still be offered a loan, but it will usually come with a higher interest rate, higher down-payment requirement, or other terms that help protect the lender and lower their risk.

The difference is that these loans come with a physical piece of collateral — a car or home — that can be repossessed if the borrower falls behind in payments or defaults on the loan. Credit card issuers don’t have the option of repossessing every item purchased through the card.

So annual fees help credit card issuers lower their cost of doing business with riskier clientele. And that’s a win-win scenario — the consumer gets access to credit, and the creditor gets a small layer of protection.

Bottom Line

Even though you may not love credit card annual fees, they exist for a few valid reasons. If you have good credit, you can likely find a credit card doesn’t charge an annual fee. But then again, you might choose to pay an annual fee on a card with enough benefits to outweigh the cost.

And if your credit isn’t great, you can strategically use a credit card (with or without an annual fee) to help improve your credit score. That means only using a portion of your available credit and making consistent on-time payments every month.

If you need a credit card to help you do that, look for one suited to your credit score range, like a rebuilding card. If you check to see if you’re pre-qualified before applying, you’ll have a good idea of your chances without impacting your credit score.