Tuesday, June 2, 2009

Consumers Lose with Credit Card Rewards

Banks seem to be getting quite generous with credit card rewards, particularly for premium cards. However, some Members of Parliament are unhappy with the fees charged merchants to pay for these rewards.

On the surface it all seems like a great idea. You buy stuff with your credit card and later you get back a percentage in cash or in points that can be used to fly or buy stuff. Premium cards are even better because the rewards are bigger. But we know there is no free lunch. Who pays for all this?

To answer this question we have to follow the money for a couple of steps. To begin with, merchants are charged fees for accepting credit cards. The amount they are charged is called the credit card interchange rate. This rate is higher for premium cards.

Of course, since merchants get to keep less of the money from a sale, they have to raise prices. So, ultimately, consumers’ credit card rewards are paid for by consumers. But, consumers actually pay extra because banks keep a slice of the interchange fees charged to merchants.

If the interchange rate is increased by 1%, prices will have to go up by about 1% to compensate, but consumer credit card rewards will go up by less than 1%. In the big picture, consumers would be better off with a rock-bottom credit card interchange rate and no rewards.

Banks have an interest in increasing interchange rates as much as possible to increase their profits. To this end they have been flooding their customers with unsolicited premium cards. Maybe merchants need to offer discounts for using either cash or credit cards with low interchange fees.


  1. It would be a good idea for retailers to offer a cash price vs a credit price. Mountain Equipment Co-op does this (they did in 1990, anyway). I would gladly pay cash if I got a 1.5% - 2.0% discount.

  2. Great post.

    Unfortunately, this is a classic case of tragedy of the commons. It would be better for everyone if consumers stopped using reward cards and paid with cash. But why would I, as an individual, want to do this? I would be out 1% of the sale price in rewards, and the store would save 2-3% on transaction fees. But even if this 2-3% savings were passed entire onto customers, it would be divided among all the stores customers. In other words, the marginal benefit of me using a rewards card outweighs the marginal cost.

  3. Anonymous: You're right that individuals have the incentive to maximize rewards (taking into account yearly fees and other factors). This is why I'd like to see merchants offer discounts for cash and credit cards with lower interchange fees. This would change the equation for individual consumers.

  4. Being stinking rich and a person who has a policy not to buy anything new, what little money I do spend, I spend in ways that help the local retailer out the most, even if it costs me the 1% cash back on my credit card and even if I don't get any benefit for paying cash. The benefit I happily give to the local retailer as thanks for him taking the risks for running a business offering services I want, in my neighbourhood.

    Therefore, I pay cash for most items bought from local retailers, debit if it is a larger purchase and credit card only if I'm 1) forced to (i.e. travel purchases or web purchases) 2) buying a large item from huge national or multi-national company or 3) may need the protection a credit card offers on the purchase.

    Even when I'm traveling (30 - 50% of the year) I use cash, taking money out of foreign bank machines using my bank card. Any excess cash at the end of the trip, I put towards the hotel and then put the remainder on my credit card.

    Using cash is a good way to become stinking rich, at least for me. I find it very hard to part with cold, hard, cash.

  5. Caddywampus: I'm not a big fan of deception, but you'd still be better off if interchange fees were low, there were no credit card rewards, and you lied to your spouse about the trip being free.

  6. If interchange rates went up by 1%, prices would not have to go up by 1%; that is, unless you meant that the the rates go up by 1 percentage point. There's a very big difference.

  7. RRMcKinnon: I assume you're talking about the distinction between rates rising by 1% of the sale price or rising by 1% of the interchange fee. I was referring to 1% of the sale price. I'm afraid that saying either "1%" or "1 percentage point" isn't enough to make this distinction.

  8. It is a loosing situation for the merchants. By giving a 1% discount on cash purchases, they are still loosing 1% on all their sales. Atleast now, they get full value from those that pay cash.

    You have grouped all consumers together but really the credit card users are profiting at the expense of those that pay cash. So it makes sense to use a credit card, making the problem worse.

  9. Anonymous: Collectively, consumers lose, by which I mean that the total amount that credit card users benefit is less than the total amount that cash-payers lose. You're right that an individual consumer can come out ahead by using a credit card with big rewards. As the first anonymous commenter said, this is a tragedy of the commons situation.