• Christopher D. Munchhof

The Real Reason Credit Cards Offer Rewards


I was out to lunch with my wife a few weeks ago and overheard a conversation about credit card rewards. A nice lady was chatting with her friend and explaining how she earned cash-back rewards for using her credit card and there were no extra fees, they just gave her the rewards. She then explained that the reason banks were willing to do this was because it encouraged spending and thus stimulated the economy, which was good for everyone! I smiled as I admired her positive perspective of the banking world.


You're Probably Wrong About Why Credit Card Companies Want You To Swipe

It seems almost common knowledge that credit card companies offer cash-back and reward points programs to encourage you to spend beyond your means and fall into debt which they then collect substantial interest on. This isn't entirely true.


Did you know that American Express only makes about 20% of it's revenue from interest charges? The largest share(55-60%) of AMEX's revenue actually comes from the fees they charge retailers to process credit card payments. Another 10% of revenue is generated by typical credit card fees(annual fees, late fees, etc.)


So knowing that interest is not the primary revenue stream for credit card companies, it's easier for us to understand the real reason they offer rewards; to keep you swiping their card and no one else's.


If It's Not All About Interest, How Can They Make Money And Pay Rewards?

Credit card companies charge merchants from 1-3.5% of every credit card transaction that takes place in their store. So with a 3% merchant fee, if you buy $100 worth of groceries, the credit card company gets about $3 and the store $97. From that $3, the credit card company might reward you $1 and still keep a profit of $2.


Here's why they'll still make more than $2 profit: rewards are almost never redeemed right away. The credit card company gets to hold on to that money and use it to earn interest until the rewards are redeemed, if they ever are. Credit card companies know that many people will never redeem all of their points. People may forget about their points and allow them to expire. They may miss payments and forfeit their points. Or the credit card company may simply end the rewards program. Additionally, the credit card companies negotiate discounted pricing for the gift cards they commonly offer as rewards.


Who Cares If They Profit, Isn't It Still Free Money?

First, we'd have to ignore the fact that most people (over 60% of credit card users) carry a balance from month to month and pay interest which completely negates any rewards they've earned. Assuming you're in the 40% crowd who carries no balance(for the time being), do rewards programs help you come out ahead financially? There has been a strong trend of more and more people playing the "beat the system game" who think by paying off their balance every single month they are actually "sticking it" to  credit card companies.


Last year, a New York Times article described experiments that proved that the mere presence of a credit card logo in a purchasing setting caused people to increase the amounts they spent.  Additionally, the 2016 Bond Loyalty Report discovered that 66% of people were willing to change the amounts they spent in order to maximize rewards. Offers for bonus points frequently cause consumers to make purchases they otherwise wouldn't, like staying at a slightly pricier hotel or dining at a more expensive restaurant. Most gas stations charge 5-10 cents more per gallon to buy gas with credit vs. cash.


Purchasing with a  rewards credit card causes you to go through the semi-subconscious process of deducting your expected rewards from the cost of the product without actually doing the math. "Yeah, I just spent $127 on Amazon, but I didn't really spend that much because I'm getting rewards back!"


Earning rewards on purchases obfuscates how much you think you're spending. You believe you're spending less, but all the data tells us that you will undoubtedly spend more.

Here's some math to consider. Most rewards cards offer a reward rate of between 1% -2%, with the majority being closer to 1%.  If you spend $5,000 in a month on your reward credit card you'd earn a cool $50. Fifty dollars for $5,000 in transactions!  The odds that you did not overspend by AT LEAST fifty dollars through the month is a virtual impossibility.


Lastly, even after spending more money to earn the rewards, people generally account for rewards dollars as extra money or unearned money and tend to spend it casually, not deliberately as they would with cash. So those rewards dollars are actually worth even less to you because you're more likely to use them inefficiently.


Can you beat credit card companies whose primary purpose in this world is skimming dollars out of your pockets? Can you beat the credit card companies' predictive analytics which help them know what you'll buy before you do? Can you beat their $1 billion in targeted advertising challenging you to beat them at their own game? No. You can't. If you think you're that special person who's beating them, they're already winning. 

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