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Why Credit Cards Offer Rewards

Trent responded to a reader the other day about the real scoop on credit cards [3] 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. 🙂