Credit card companies are in the business of making money, so it might seem counterintuitive that they would pay you to use their cards. However, behind the scenes, there is a complex system of fees and incentives that make it possible for credit card companies to offer rewards to their users. In this blog, we will explore the world of credit card rewards and explain how credit card companies pay you to use their cards.
Who’s paying for all your credit card points?
The funding for credit card points or rewards comes from a combination of sources, including interchange fees paid by merchants, interest charged on balances carried over from month to month, and fees charged to cardholders for certain transactions or services.
The primary source of funding for credit card rewards is the interchange fee paid by merchants. When a cardholder makes a purchase with their credit card, the merchant is charged an interchange fee, which is a percentage of the transaction amount. This fee is typically higher for rewards credit cards than for non-rewards credit cards, which allows credit card companies to fund their rewards programs.
In addition, credit card companies may earn interest on balances that are carried over from month to month, which can also help fund their rewards programs. Some credit card companies may also charge fees to cardholders for certain transactions or services, such as balance transfers or cash advances, which can also contribute to the funding of rewards programs.
It’s worth noting that while credit card rewards can be valuable for cardholders who use their cards responsibly and pay their balances in full each month, they may not be a good deal for everyone. Rewards credit cards often come with higher interest rates and fees than non-rewards cards, so it’s important to consider the costs and benefits before signing up for a new credit card.
The Credit Card Fee System
To understand how credit card rewards work, we first need to understand the fee system that underpins the credit card industry. When you use your credit card to make a purchase, the merchant pays a fee to the credit card company for processing the transaction. This fee is known as the interchange fee and it is usually a percentage of the transaction amount. The interchange fee varies depending on the type of card used and the type of merchant accepting the card. For example, a merchant might pay a higher interchange fee to accept a rewards credit card than a standard credit card.
The credit card company then takes a cut of the interchange fee and passes the rest on to the bank that issued the card. The bank uses this fee to cover the cost of running the credit card program, such as customer service and fraud protection. The bank also makes money by charging interest on any balances that are carried over from month to month.
The Credit Card Rewards System
Now that we understand how the fee system works, let’s take a look at how credit card rewards are funded. When you use a rewards credit card, the credit card company pays you a percentage of the transaction amount in the form of rewards points, cashback, or other incentives. The credit card company can afford to do this because the interchange fee paid by the merchant is higher for rewards credit cards than for standard credit cards.
For example, a merchant might pay an interchange fee of 1.5% for a standard credit card, but 2.5% for a rewards credit card. The credit card company takes a cut of this interchange fee and uses it to fund the rewards program. This means that the more you use your rewards credit card, the more money the credit card company earns in interchange fees, and the more rewards they can afford to pay you.
Incentivizing Card Use
Credit card companies also use rewards programs to incentivize users to spend more money on their cards. For example, a credit card might offer 2% cashback on all purchases, but 5% cashback on purchases made at grocery stores. This encourages users to use the card more frequently at grocery stores, which in turn generates more interchange fees for the credit card company.
Credit card companies also offer sign-up bonuses and other incentives to attract new users. For example, a credit card might offer a sign-up bonus of 50,000 points when you spend $3,000 in the first three months of opening the account. This encourages users to spend more money on the card right from the start, which generates more interchange fees for the credit card company.
In conclusion, credit card rewards are funded by the interchange fees paid by merchants when you use your credit card. The higher interchange fees paid by merchants for rewards credit cards allow credit card companies to fund rewards programs and incentivize users to use their cards more frequently. By understanding the fee system and the incentives offered by credit card companies, you can make smart choices about which credit cards to use and how to maximize your rewards.