Key takeaways

  • Credit card rewards are paid for by issuers, which indirectly pass the bill along to consumers that are charged fees and interest for using their cards
  • The merchant middlemen also indirectly pay for credit card rewards by paying interchange fees, typically 1 to 3 percent of each purchase that a consumer charges to their card.
  • The best way to maximize your credit card rewards is to keep from paying fees and interest on your card altogether. This way, you’re not spending all of your cash back or canceling out your accumulated points value on charges you could’ve avoided.

Whether it shows up in your inbox or mailbox, you’ve probably received a credit card offer at some point. These offers often have headlines like, “Sign up and get 80,000 bonus points!” or “Earn $300 cash back when you meet the minimum spend requirement.”

Of course, they sound enticing: Who doesn’t want free money or points that will allow them to meet their financial goals or travel the world?

But what are credit card rewards in reality? The idea is simple. You pay for items using your credit card, and in turn, the card issuer will reward you with points, miles or cash back. Credit card rewards have a set value that can vary based on offers and the credit card issuer.

But if they are just “free”, as advertisements may make it seem, why do credit card issuers have them at all? In short, credit card companies pay for rewards. To understand how this setup is profitable for those companies, you need to know how credit card issuers make money.

Here’s what you need to know about the complex network of industries that lead to the rewards you earn with your credit card:

Am I paying for the rewards I earn?

Sometimes, but indirectly.

“At a minimum, you pay for some of the rewards you earn through increased prices on the goods and services you buy,” says Dan Stous, certified financial planner (CFP) and lead wealth advisor at Flagstone Financial Management. “Credit card companies charge merchants a fee to accept cards as a payment option, and merchants pass through that cost to you in the form of increased prices.”

“You can earn a lot more than you pay for if you do it right,” says Stous. “Merchants charge everyone the same price, so you’d pay higher prices regardless of whether you use a card that offers points or you paid in cash.”

How do credit card issuers make money?

Credit card companies make money by way of three types of fees.

1. Interest

Credit card interest may be the best-known revenue stream for issuers. The annual percentage rate (APR) range of a card is legally required to be displayed before applying for a card, and your exact APR will be included in the card’s Schumer Box, which is in the information packets sent with new credit cards. This box includes bullet points of a card’s most important charges and fees.

“For credit card users who pay their bills in full, the credit card rewards model is still very much alive and well,” says Bankrate senior industry analyst Ted Rossman. “I stress paying bills in full because the math only works out in your favor if you pay in full and avoid interest.”

Interest payments are avoidable, as they are applied to outstanding balances. If you pay off your credit card in full and on time each month, you shouldn’t be charged interest on your balance.

“Even occasionally carrying a balance can outweigh the value of any rewards you earn,” says Rossman. “If you have credit card debt, focus on that rather than rewards. Get the lowest interest rate you can or just stick to cash or debit.”

2. Fees

Credit card fees come in various forms, including:

  • Annual fees. The price you pay each year to carry the card.
  • Late fees. What you pay when you miss the due date for your minimum payment.
  • Cash advance fees. A fee for borrowing cash from your credit card, such as using it to withdraw money from an ATM.
  • Balance transfer fees. What you pay when you move debt from one credit card over to your new card.

Unlike with interest, fees associated with credit cards are not always avoidable.

For people who have a limited credit history or poor credit, subprime cards with fees may be the only option available. On the other hand, many top rewards cards will also come with high annual fees — though they usually make up for the fees in rewards and perks.

3. Interchange

For the average consumer with a credit card, interchange fees may be the least familiar on this list. However, if you’re a business owner or merchant of any kind, interchange fees will be all too familiar.

Every time a credit card is used to pay for a good or service, the merchant will be charged an interchange fee ranging from 1 percent to 3 percent of the total charge. The name “interchange” refers to the complex payment network that facilitates these charges. And the fees associated with it vary, based on the number of transactions processed by the merchant.

Brian Riley, director of the credit research group for Mercator Advisory Group, says that while interchange fees may seem high, lowering them could do more harm than good. “In many studies on the Australian market, where the Reserve Bank imposed interchange price controls, few, if any, consumers benefited from the mandated reductions,” Riley says.

Riley is not alone in this belief. “The biggest threats to credit card rewards would be if interchange fees were capped, something that has happened in Europe on credit and debit cards, but only debit cards in the U.S.,” says Rossman.

To understand why capping interchange fees could hurt consumers, you must understand some of the legislative forces that impact the credit card market. Specifically, consider the Durbin Amendment, which was added to the Dodd-Frank Act in 2010. According to an economic brief released by the Federal Reserve Bank of Richmond shortly after its passage, the Durbin Amendment “had limited and unequal impact on reducing merchants’ costs of accepting debit cards, and … for some merchants [raised] costs.”

3 tips for avoiding extra fees

1. Know what you’re signing up for

Before choosing your next credit card, make sure you know the annual fee and interest rate associated with the card. High annual fees are one of the most avoidable costs of a credit card, and many great rewards cards charge no annual fee.

It’s also important to make sure the rewards will offset any costs of the card.

“Some airline cards offer perks like free checked baggage, memberships to ride-sharing VIP programs or airport lounge access, and those perks can be really valuable,” says Stous. “But if you rarely use the card, don’t earn many points, don’t use any of the perks and pay a hefty annual fee every year, you might actually be losing money.”

2. Always pay off your balance in full

Added interest can quickly change a credit card from a useful tool to a financial burden. Credit card issuers profit from interest, and some of the most common fees associated with credit cards are linked to late payments. When choosing a credit card, it’s important to only spend what you are realistically able to pay off in a month, or you run the risk of losing money rather than earning rewards.

If you need to use a credit card for a large purchase and you know you’ll need to carry a balance, consider planning ahead with a credit card that offers a 0 percent introductory APR on purchases. These cards won’t charge you interest on purchases, typically for a set introductory period like 12 to 24 months.

3. Stay away from cash advances

A cash advance can seem like a great option to get money quickly, but cash advances are always associated with a steep cost. In addition to steep interest rates, credit card issuers can charge between 3 percent to 5 percent on the cost of the advance, which can add up quickly.

Unlike normal charges on your credit card, there is no grace period before interest is accrued on a cash advance. As a rule of thumb, it’s best to avoid cash advances unless absolutely necessary.

The bottom line

Credit card issuers are able to offer lucrative rewards credit cards to cardholders because of the interest and fees they collect from other customers and merchants. So the key to making the most of your rewards credit card is to avoid carrying interest, which will almost certainly outweigh your rewards yield.

Also, be mindful of the fees associated with your credit card — whether it’s an annual fee, balance transfer fee, foreign transaction fee or cash advance fee — to make sure the benefits of your card come out ahead of the costs. While paying an annual fee is often worth it to get access to generous rewards, frequently paying other fees on your credit card will likely erase your rewards earned (and essentially pay for someone else’s).