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Why Credit Cards Offer Rewards

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Trent responded to a reader the other day about the real scoop on credit cards and, while the premise was correct in that if you carry a balance then the rewards on a card don’t matter, his logic was flawed. While he doesn’t come out and say that credit cards offer you rewards because they expect you to carry a balance (he sort of just says that Americans are badly in debt and those in debt are more likely to be in more debt and credit card companies want to leverage that) but that’s actually not why they offer you rewards, it’s merely a benefit that comes with a positive expected value.

The real reason why credit cards offer rewards is because they’re paying you less than what the merchant is paying them in order to process the credit card transaction. Everytime you charge something, several companies take a piece of the action and the merchant getes somewhere in the neighborhood of 3% off the top. In order to entice you to put their card in your wallet, they offer to kick back some of it to you as 1% cashback. Many consumers don’t know this and now all those “no charging to credit cards unless the purchase is over $10″ signs and the lack of Discover/American Express acceptance probably makes more sense now (Discover and AMEX have the highest fees).

Here’s another sneaky tactic since we’re on the subject. Some card issuers offer reward points such as 1 point for every $100 spent. If you can convert that point into a penny dollar, then you have basically 1% cashback but that’s often not the case because anytime they can shave a little off the conversion then the credit card company’s profits increase. They will generally offer products or giveaways or some other tangible non-cash item that, if you were to convert the points to cash, you wouldn’t buy at the stated price. So what about 5% cashback on gas? Aren’t the credit cards losing money on that transaction? Yes, but they figure to get into your wallet and so you might use the same card for something else and thus they expect to make money off the whole arrangement.

So, credit cards aren’t depending on you getting in debt but they certainly don’t mind it one bit. :)

{ 8 comments, please add your thoughts now! }

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8 Responses to “Why Credit Cards Offer Rewards”

  1. FMF says:

    Uh, I don’t know. I think I agree more with Trent.

    When I worked with MBNA on a credit card program for a previous employer, they told me the merchant fees were simply enough to cover their costs. The REAL money was in people carrying balances over time.

  2. The ~3% they charge covers infrastructure and operating costs for having the CC network in place (phone lines, computer center, support, etc). They MIGHT get some profit, but nothing like the 12.99%-29.99% interest they charge cardholders to USE that network. Worst that can happen is they break even on the sale.

  3. Triston says:

    It would be fine if the interchange fee was just enough to cover the cost but that isn’t the case. Thanks to new technologies, the actual cost to process the transaction has declined while the interchange fee has skyrocketed. It’s the biggest hidden credit card fee nobody has ever heard of. ($40 billion a year!)

    We’re doing something about it at UnfairCreditCardFees.com

  4. FIRE Finance says:

    We also agree with FMF and Trent about the fact that the credit card companies profit primarliy from the money charged as interests on balances carried. But Triston points out a new fee which we did not know of i.e. interchange fee. We shall investigate that this week. Thanks Triston.
    Kudos for the great post.
    Cheers,
    FIRE Finance

  5. buttercrud says:

    A penny is 1% of a $100? News to me.

  6. jim says:

    Whoops, see points are confusing!

  7. Tommy says:

    I actually wrote little notes to myself on my credit cards. This way I’m not confused about which to use for what. My Amex small biz card is good for 5% back on gas, cell phone, and office supplies so I wrote “5% back gas, office, cell” and also “0% until 02/08″ on a little post it, cut it down to a tiny rectangle, and taped it to the front of my card so I know exactly what to use that card for. I’ve done this for all of my rebate cards to maximize my rewards.

    On that same, note, the Amex Simply Open card is nice because there are no points, no accrual limits, or any of that nonsense. They pay out the rebate every month without you having to do anything. I get about one or two free tanks of gas each month from Amex (about $30-50!). Not bad for doing nothing but swiping this card instead of using my other cards.

  8. In either event, I’ll be happy to take the 1-5% reward. If a store wants to offer a 3-5% discount for not using a credit card (as some do), then I will consider using debit or even, *gasp* cash.


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