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.
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If you patronize small stores, you can usually negotiate a cash discount.
It is important to point out that as most businesses accept credit cards. Small, “mom and pop” stores that don’t accept credit cards typically have higher prices, in my experience then large retail chains, so the benefit is lost.
Also, although 2.5% may be the merchant processing fee for a rewards card, many people do not have such cards. I did soem google-ing and found 3 businesses that quoted their average merchant processing fees. They were 1.6%, 1.71%, and 1.75%. Using 1.7% and the 80% cc usage you used, the price comes out to be 1.36%. If I have a cc with 1% cash back + 3% at grocery and gas, it prolly comes close to 1.36%. To that you can tack on the convenience of the grace period.
So, I’d say that I, along with many Transactors, am probably about breaking even vs. what it would be like in a world without credit cards.
p.s. wikipedia says 2%, but i’m leaning toward the ‘real’ merchant results.
Harry Sit says
Thank you for your comments. Most businesses accept credit cards because there’s an army of transactors demanding on using credit cards and getting their rebates and miles. Industry stats I read said 1/3 of all credit card users are Transactors and they generate 1/2 of the transaction volume. I don’t think the industry would be pursuing the Transactors’ business if they merely break even on them. The DOJ document I quoted in the post showed Transactors are indeed profitable to the card companies.
Customers Revenge says
Not sure if it is true that prices are up 2% because of credit cards.
First: Just because things cost less to the retailer doesn’t mean you get a discount: They just keep the 2% for themselves because the product is still worth the same amount to you.
Second: the credit card companies create more demand (people can buy with money they don’t have), which creates more supply, which lowers the prices. I wouldn’t be surprised if the credit card industry lowered retail prices and increased retailer profits.
However, they also bankrupt the consumers’ futures in the process.
I’d say the answer is all of the above. I’ve always just considered that the cc company has revenue — from different sources (interest, merchant fees, etc.) and in return for my business (the fees my merchants pay for my purchases), I get a small reward.
credit card assistance says
I think it’s credit card holders who pay for the rewards. If you look at the reward credit card features, you see that they have higher than usual APR and annual fees. What’s more, if you put just every purchase on your credit card, like most transactors do, your creditor also has its share. Companies are no fools really.
If the sales volume of CC transactions is less than half of a merchants total volume then people that pay cash are subsidizing that reward.
Say a merchant has $1,000,000 in sales of which $500,000 is paid w/ CC. The merchant pays 2% of $500,000 ($10,000) to the CC companies. This $10,000 is 1% of their sales so they raise prices by 1% to pay this cost.
A person with a 1% cash rewards card would therefore about break even in this scenario, as the reward offsets the rise in prices. A person paying in cash on the other hand would be 1% poorer, in order to subsidize the use of CCs by other patrons.
It then follows that a CC user only comes out ahead with a reward if sales volume is less than half CC and lose money if its more. Of course, people that pay in cash lose money in all scenarios but lose more as CC volume goes up.
You really have to hand it to the CC companies, they have applied game theory principles masterfully. If no consumer used credit cards then prices would be lower. CC companies provide an incentive through “rewards” to use them. But the “reward” is only a reward if a few people use CCs. And once CC use becomes dominant people still have an incentive to use them because they will lose less by getting a “reward” than if they paid in cash.
Y’all are leaving the cost of handling cash. That is an important reason why fast food restaurants are now promoting the use of plastic. Plastic also inhibits theft by employees.
I agree with a lot of the comments here. Credit card companies didn’t raise prices on products. Sure some stores will include the transaction fee in products, but all that does is drive prices up in their store and smart shoppers will find other places to shop. Also stores can up prices for any reason and claim it was due to these fees even if it is not the reason. Again smart shoppers will shop around.
Plus many people spend with money they don’t have (ie credit cards) and then don’t pay of the balance. Not only has this, as other comments have suggested, caused an increase in spending (the merchants get paid their money) but credit card companies are making a killing off of interest and fees. With an average rewards credit card APR hovering around 19.4 percent thats a whole lot of money to throw around by the company. Take 1 percent out (as that is the most popular reward back amount) and hand that to the rewards program and those that pay off their balances in full get the rewards free and those who don’t simply put the ‘rewards’ right back into the system through interest plus the other 18 or so percent their still paying.
Rewards programs really pay for themselves and the most likely scenario is that companies take a fraction of different incomes they earn (say 0.2 % of merchant fees and 0.8% from interest payments and late fees) to ‘pay out’ 1% back rewards.
You may or may not already be aware of this but in some other countries they have a solution for this. They pass any transaction related costs resulting from your use of a credit card directly to you. In that way there is an incentive to use cash, the prices do not have to all be raised just to protect from credit card users, and there is no mystery as to what the transaction fees are.
Harry Sit says
John – Yes, I know in some other countries the customer pays a surcharge for using a credit card and I think it’s a very fair arrangement. If one wants to get the billing convenience, added security, and rewards, he/she pays for it. If another person thinks it’s not worth it, he/she doesn’t pay for it. Unfortunately credit card surcharging is illegal in the United States.
Great article! It took several Google searches to find someone actually doing what journalists are supposed to do: Follow the money! Keep up the good work!
I really like that you were able to make the twist at the end. The system is messed up, but if you can’t beat ’em, join ’em. I also lament the way it works, but the prices will be the same no matter how I pay, so we might as well get a little bit back in the process.
I use Chase’s Freedom and the BP Visa (5% on gas, 2% on travel/dining).
(Disclosure: I used to work for Chase [as a teller], and I do not own any JPM stock.)
Maritza Salvado says
I agree 100% that these rebates have caused prices to go up. The merchant gets charged by the credit card companies (they never loose a penny). The worse part is, some of us, such as lawyers (at least where we are), are not allowed to charge their clients those fees. The alternative is to raise prices, but in a competetive market, it is not always possible.
The USA is out of control, the banking industry, the government itself and including the communication industry are doing whatever they want with us. Damned Republicans!
Bll Davis says
Gandalf-You need to tell the whole story about chase freedom card–Your rewards do not kick in until you have acured $1,5000 then your rewards kick-in, Plus I am very sorry to see that you have an account with chase-if you did work their you should know this is a VERY BAD company.