How Do Cash Back Credit Cards Make Money?
Have you ever wondered how credit card issuers can offer customers cash back, and still make a profit? In fact, credit cards are one of the most consistently profitable products in the banking industry, and they continue to generate tremendous profits even during the depths of the last recession, despite offering cash back rewards.
Where credit card profits come from
Credit cards offer issuers numerous sources of profits that more than offset the cost of cash back rewards. The most important income any credit card issuer receives is from merchant fees. These are fees paid by the businesses that accept credit cards, and these fees can be between 2% and 4% of the cost of each transaction. In addition, credit card issuers earn income on interest charges that cardholders pay, which is typically in the 10% – 20% range, but can sometimes be higher. Credit cards also make money from fees including late fees, balance transfer fee, cash advance fees, and foreign transaction fees. Finally, some of the most generous cash back cards charge an annual fee.
When you consider the money earned from merchant fees, interest charges, and cardholder fees, you almost have to wonder why credit card issuers don’t offer customers even higher percentages of cash back while still making a profit. In the intensely competitive credit card industry, card issuers typically have to spend hundreds of dollars in marketing and advertising to acquire each new customer. The card issuer must also provide customer service by maintaining a web site and a call center while administering monthly statements and processing payments. Some card issuer expenses include offering travel insurance and purchase protection benefits, as well as the production of new credit cards, now equipped with expensive embedded microchips. And most importantly, credit card issuers are providing a loan to customers that is unsecured, and there’s always the risk that the cardholder will default, resulting in a loss.
What about bonus rewards
Many credit cards offer bonus rewards of up to 6% for certain purchases, which would not seem to be possible if merchant fees are in the 2-4% range. Credit card issuers have developed all sorts of ways to offer these higher levels of rewards while still maintaining profitability. One way is for card issuers to limit the amount of purchases eligible to receive these higher levels of rewards. For example, the American Express Blue Cash Preferred offers 6% cash back on up to $6,000 spent each calendar year at US supermarkets, so card issuers will only pay $360 in cash back bonuses to cardholders who reach this threshold. Another example is the Chase Freedom, which offers 5% cash back at featured merchants and merchant categories, but only on up to $1,500 spent each quarter.
So while a credit card issuer might absorb a slight loss when offering bonus rewards—hence their limitation—card issuers are confident they can make an overall profit by encouraging customers to use their card all of the time, even when they are not receiving an additional bonus. This is roughly analogous to a casino that will not turn a profit on every patron, but will always make money on the collective gambling revenue. And just like a casino likes to encourage customers to visit by celebrating its winners, the credit card issuer encourages use of their cards by offering bonuses on particular items.
How to ensure that you always come out ahead
Unlike gamblers, credit card users can be assured of consistent cash back returns by following just a few simple rules. First, don’t use a cash back card unless you avoid interest charges by paying your monthly statement balance in full and on-time. If you need to carry a balance from time to time, as approximately half of all American credit card users do, then you are better off avoiding cash back rewards and focusing on finding a credit card with the lowest possible interest rate. A card that offers cash back rewards will usually have a higher standard interest rate than a similar card that offers no rewards.
Next, you need to ensure that you are not one of the people who pays fees to your card issuer. By making all of your payments on-time, you can avoid late fees. Furthermore, you should never incur cash advance fees from using your credit card at an ATM, and as someone who never carries a balance, you should have no need to ever pay balance transfer fees. And when traveling outside of the United States, you can use one of the many cards that has no foreign transaction fees. Finally, it’s okay to pay some annual fees to use the most competitive cash back card, but you just need to do the math and ensure that you are earning enough additional rewards to justify the fees.
By understanding how cash back credit cards work, you can earn the most rewards possible from these valuable products.