As counterintuitive as it may sound, offering 5% cash back on goods users purchase actually increases a credit card company’s profit margins. The reasoning behind this lies within how credit card companies generate money. (Sometimes a bank or credit union issues the credit card). First, by offering an incentive to use credit cards as a form of payment over cash or checks, it increases the probability that the financial institution will be able to collect interest on any remaining balance left unpaid.
Second, by offering enticing reward options, financial institutions can depend on users to pay more often with a credit card; this leads to more interchange fees. Interchange fees are processed and transferred to the issuer as a form of revenue when a customer uses his or her credit card. By implementing an attractive rewards program, it increases spending and thus interchange fees.
Another reason why financial institutions offer rewards is to increase their market size and attract customers in new market segments that might not otherwise be inclined to use credit cards. With a multitude of different payment options available, institutions need to offer attractive options to differentiate themselves from their competitors. Also, if a good rewards program is in place, it decreases the number of users who switch to different companies and increases the chances existing users remain loyal customers. Loyal customers mean more credit card transactions being processed, and more credit card transactions mean higher interchange fee revenue.
Credit card reward programs may sound attractive to consumers; however, they are not always beneficial. Consumers need to understand the credit card interest rate, be cautious of how much they spend, and realize their purchasing power if deciding to participate in the reward program.
Written by: Cuihua Lin, Financial Wellness Peer Educator.
Reviewed by: Kathy Sweedler, Consumer Economics Educator, University of Illinois Extension.