Many people will not even consider applying for a credit card that carries an annual fee, but I think that this categorical exclusion is a huge mistake because the vast majority of top-notch credit cards charge an annual fee and provide benefits that greatly outweigh that fee. With that in mind, here are some important factors to consider when evaluating whether a card is “worth” its annual fee:
The value of rewards on actual spend. This is the most obvious consideration, but it’s a bit trickier than it seems at first glance. The question isn’t simply whether the expected value of rewards generated by spending on the card outweigh the annual fee; the question is whether the expected value of rewards generated by spending on the card less the opportunity cost of spending on the card outweigh the annual fee.
To illustrate this point, let’s consider the Chase Sapphire Preferred card, which is undoubtedly one of the best cards, if not the best card, on the market. The card carries a $95 annual fee (the fee is waived for the first year, but let’s assume that we’re beyond that first year and considering whether to keep the card and pay the annual fee). The Sapphire Preferred card offers two Ultimate Rewards (“UR”) points per dollar on travel and dining purchases and one UR point per dollar on all other purchases.
If we simply compared expected value of rewards generated by spending on the card to the annual fee, the analysis would go something like this:
I expect to put $15,000 of travel and dining expenditures on the card during the next year, which will yield 30,000 UR points. I value UR points at 2 cents apiece, so my spending will create $600 worth of value. Annual fee justified.
But that’s not the end of the analysis because I know that I can get 2% cash back on all purchases by using other credit cards, so my marginal benefit of using the Sapphire Preferred card is actually $600 minus what I would have earned if I hadn’t used the card – $300 (2% of $15,000) – for a net benefit of $300. Still easily justified, but by a smaller margin.
The value of having – as opposed to using – the card. Lots of credit cards provide valuable benefits that have nothing to do with how much you actually spend on them. Airline cards are great examples, as they typically offer one free checked bag to the cardholder and a companion. That benefit alone is worth $100 to a couple that checks one bag each on a single round-trip flight. Hotel cards also typically offer valuable benefits to cardholders that are not dependent on actual spend, typically in the form of elite status – like the Citi Hilton Reserve card, which confers Hilton Gold status to those who hold the card – or a jump-start on obtaining elite status in the form of stay or night credits – like the Starwood Preferred Guest card, which credits cardholders with 2 stays and 5 nights at the beginning of each year. (As a benchmark, Starwood gold status is earned when a person accumulates 10 stays or 25 nights in a given year).
Signup bonus. Annual fees are often dwarfed by signup bonuses. The Chase Sapphire Preferred card, for example, offers a 40,000-point signup bonus if you spend $3,000 within the first three months of opening your account. If you accept my premise that UR points are worth approximately 2 cents apiece, that bonus offsets the first nine years of annual fees (the first year is waived, and the next eight years would incur a $95 annual fee), and then some.
Retention/anniversary bonuses. Some credit cards offer an annual bonus that offsets, or partially offsets, the annual fee associated with the card. The Hyatt Visa card, for instance, provides cardholders with one free night at any category 1-4 Hyatt each year, which, in my opinion, more than offsets its $75 annual fee. The Sapphire Preferred card also provides an annual bonus in the form of a 7% “dividend” on the points earned in the prior year. So, for example, if you earned 30,000 points in 2012, you would have received a 2,100-point bonus at the beginning of 2013.
The value of cards that have no foreign transaction fees. This point is pretty self-explanatory, but it bears mentioning that cards with no foreign transaction fees – like the Sapphire Preferred card, the Hyatt Visa card, the Capital One Venture card, and the American Express Platinum card – provide a great deal of value to international travelers. Keep in mind that most credit cards will ding you with a surcharge of roughly 3% on purchases made in foreign currencies, so avoiding that fee can generate substantial savings.
To sum up, I think it’s important to stress that I am not suggesting that annual fees, as a general matter, are justifiable with a bit of creating thinking. There are lots and lots of terrible credit cards out there that have the nerve to charge an annual fee, and there are some excellent credit cards with annual fees that are too high to justify (for me, at least). The American Express Premier Rewards Gold card is an example of the latter category; it’s an incredible Membership Rewards point-earner, and I nabbed it for the sign-up bonus and fee-free first year, but plan to downgrade the card before the $175 annual fee hits my account.
So by all means be skeptical. But don’t categorically reject credit cards with annual fees, because you’ll end up throwing the baby out with the bath water.