There is debate about whether one should charge everything on credit cards for reaping the rewards (cash rebate or miles) or pay everything by cash (and by debit card and checks). In this post I examine the source of the credit card rewards. If I charge everything on credit cards, pay the balance in full every month, and receive rewards and rebates, where do the rewards and rebates come from? Who pays for them?
I see four potential candidates:
- The credit card companies;
- The establishments which accept credit cards, i.e. stores, restaurants, etc. (“merchants”);
- Other credit card holders who pay interest charges to the credit card companies;
Let’s take a look at each one.
1. The credit card companies. The credit companies pay for the rewards directly to me, but they are unlikely the source. For each charge I make, the credit card companies levy a fee on the “merchant” which accepts my charge. The fee they charge to the merchants is larger than the rebate they pay to me. The fee is also larger if I use a reward card than if I use a non-reward card. So the cost of the rebate is built into the credit companies’ pricing structure.
2. The merchants. The merchants pay a fee to the credit card companies for each charge. If 80% of their sales are charged on credit cards which cost them 2.5% of the gross sales, that means credit card fees are 2% of their sales. That number has to be factored into how they price their products and services. Naturally prices are 2% higher than what they would’ve been without credit cards.
3. Other card holders. Credit card holders who carry a balance and pay interest charges to credit card companies are called Revolvers because they carry a revolving balance. Credit card holders who pay off their balances in full every month are called Transactors because they are in for the transactions. Revolvers are more profitable to the credit card companies than Transactors, but that doesn’t mean the Transactors are not profitable to them. According to this DOJ document,
… indeed, MasterCard’s own documents confirm that its issuers earn at least a 15% return on equity with some “pure transactors” – those transacting sufficient volume.
The profit margin might be smaller from the Transactors, but they are positive, more steady, and less risky.
4. Myself. Now it comes to myself. I paid for the rewards and rebates through higher prices for the products and services I buy. In pursuit of a 1% rebate, I helped push the prices higher by 2%. The credit card industry made a clever rule that disallows different prices for cash and credit. Without this rule, it makes no sense to pay a 2% surcharge in order to get 1% back in rebate. By enticing its customers with rewards and rebates, the credit card industry carved out a nice 1% from almost every retail sale for itself. Very smart!
The rewards and rebates from credit cards are not free lunch. There is no free lunch. They are not a gift from anybody. I paid for every reward and rebate I received and then some. What should I do about it? Well, because I already paid for it through higher prices, I might as well grab the rewards and rebates. However, I would prefer that the credit card industry’s no-surcharge rule be declared illegal. Then I will happily pay cash in exchange for a discounted price.
Instant diversification in a low-cost ETF portfolio. Convenient and disciplined with automatic rebalancing. Minimize your taxes. Betterment.com.