Whether it shows up in your inbox or mailbox, you’ve probably received a credit card offer at some point. “Sign up and get 80,000 bonus points!” “Earn $300 cash back when you meet the minimum spend requirement.”
The offers sound enticing; who doesn’t want free money or points that will allow them to travel the world? But what are credit card rewards in reality? If they are just “free” money, 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.
What are credit card rewards?
Credit card rewards may come in different forms, including points, cash back and miles, but they are all perks that issuers use to incentivize customers to use their cards.
The idea is a simple one: 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.
The way you redeem credit card rewards also depends on the card issuer, but typically you are allowed to redeem them when you reach a certain threshold of rewards earnings. For example, if you had the Citi® Double Cash Card, you could begin to redeem your rewards once you accrued a minimum of $25 in cash back.
How do credit card issuers make money?
There are three ways that credit card companies make money:
Credit card interest may be the most well-known revenue stream for issuers. The 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 Schumer Box, which will be within the information packet sent with a new credit card.
“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.”
Credit card fees come in various forms, including annual fees, late fees, cash advance fees and balance transfer fees. 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.
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, explained that while interchange fees may seem high, lowering them could do more harm than good. According to Riley, “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 is not alone in this belief. Rossman says, “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.”
To understand why capping interchange fees could hurt consumers, you must understand some of the legislative forces that impact the credit card market. Specifically, the Durbin Amendment, added to the Dodd-Frank Act in 2010, which, according to a 2015 review, “had limited and unequal impact on reducing merchants’ costs of accepting debit cards, and … for some merchants [raised] costs.”
Am I paying for the rewards I earn?
In short: sometimes, but indirectly.
According to Dan Stous, a CFP and lead wealth advisor, “At a minimum, you pay for some of the rewards you earn through increased prices on the goods and services you buy. 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.”
Three tips for avoiding extra fees
1. Know what you’re signing up for
Before choosing a new 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. As Stous explains, “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. 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.
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 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).