Who’s Footing the Bill for Your Rewards?

by: Richard A. Anderson

How often in the past month have you received a credit card offer with a large sign-up bonus and lofty on-going rewards? Sign-up bonuses can be a flat dollar amount, say $500, or a promise to match any cash back rewards you may earn within the first 3 months. On-going rewards can be cash, points, or travel perks. No matter your need there is sure to be a credit card issuer out there trying to entice you to sign up for their card. Some people accept the sign-up bonus and on-going rewards and don’t think twice about it. Others, though, see these offers and wonder, “What’s the catch?”

If you fall into the second group who are curious about how credit card issuers can pay for bonuses, rewards, and perks you don’t need to be skeptical. The offers are real. The credit card issuers will not wave a magic wand and make your bonus, rewards, or perks disappear into thin air. There may be fine print on how you can redeem your points or travel perks, such as blackout periods for redeeming travel points for flights. But that’s nothing new.

So, where does the money for credit card rewards come from? The answer may surprise you.

Money for credit cards rewards actually comes from credit card customers themselves, as well as from merchants.

Credit card issuers generally derive their revenue from three main sources: interest, fees, and interchange.

Interest and fees are fairly straight-forward. Credit card issuers charge an interest rate to customers who do not pay their balance in full each month. The most common fees charged by credit card issuers to customers include annual fees, transaction fees (balance transfer and cash advance), and penalty fees (late payment, over-the-credit-limit, and returned payment). Federal law requires these costs to be prominently disclosed in a chart when you sign-up for a new card. These are the costs borne by credit card customers to fund rewards.

Interchange, however, is a term that is not as well-known because it’s effectively invisible to customers. When you use your credit card, the merchant pays a fee to accept the payment. This fee is paid to the credit card issuer and is typically a flat 10-cent fee plus 1% to 3% of the purchase amount.

Interchange rates are set by payment networks, such as Mastercard, Visa, American Express, and Discover. These rates are not disclosed to customers because they are charged to the merchants. However, merchants pass along these costs to customers by including it in prices. It’s effectively a hidden fee. One of the only places it’s not hidden is at gas stations, where it is common to see two different prices for cash and credit.

Among major credit card issuers, interest is usually the biggest share of overall revenue. Fees and interchange are smaller contributors to overall revenue.

Even though a large portion of the money for customer rewards comes from customers themselves, there are steps to take to ensure you aren’t paying for a card’s rewards many times over. Or even worse, paying for someone else’s rewards.

1. Pay with your credit card. As we previously mentioned, stores bake the interchange rate into their prices. If you pay with cash, you are paying a higher price and not receiving the benefits of the credit card rewards.

2. Pay your balance in full and on time. When you do so, you won’t pay interest or penalties.

3. Consider the benefits of an annual fee credit card. The rewards you earn should far exceed the card’s annual cost. If the annual fee is greater than the annual rewards you earn, consider a no-fee card with rewards.

4. Look out for spending requirements for sign-up bonuses. Sign-up bonuses typically require you to spend a certain amount in order to receive the bonus. For example, you may have to spend $5,000 in the first quarter to receive a $500 bonus. This can be a terrific deal, unless you are spending on things you don’t need simply to get the $500 bonus.

Get the card that fits your needs. Rewards cards come in many flavors. You can earn cash back, points, or travel perks. And each of these flavors has a twist. Weigh the benefits and drawbacks of each card option to determine how you can maximize your rewards.