How do credit card companies make money off of cashback?

Credit card companies often entice consumers with lucrative cashback offers, making it seem like they are giving away free money. However, these companies are in the business of making profits, and cashback programs are no exception. This article explores the various ways credit card companies manage to make cashback programs profitable for themselves.

Cashback programs are designed to reward consumers for using their credit cards by returning a percentage of their spending back to them. For example, the Chase Freedom Rewards Card and the Discover it Card offer up to 5% cashback on certain purchases. While these offers appear generous, they come with conditions and limitations that benefit the credit card companies.

Annual Caps and Category Restrictions

Most cashback programs have annual caps and category restrictions. For instance, the Discover it Card offers 5% cashback on purchases, but only in specific categories that change each quarter and up to a limit of $1,500 in spending per quarter. Similarly, the Chase Freedom card has a $1,500 spending cap per quarter for earning 5% cashback, with any additional spending earning just 1% cashback.

These limitations ensure that while the advertised cashback rates are high, the actual amount returned to consumers is controlled and limited. This helps credit card companies manage their costs while still attracting consumers with high-percentage cashback offers.

Revenue Streams for Credit Card Companies

Credit card companies have multiple revenue streams that make cashback programs profitable:

1. Merchant Fees

When a consumer uses a credit card, the merchant pays a fee to the credit card company, known as the interchange fee. This fee is typically between 1% to 3% of the transaction amount. A portion of this fee is used to fund the cashback rewards. By encouraging consumers to use their credit cards more frequently, credit card companies increase the total merchant fees they collect.

2. Interest Charges

A significant portion of credit card company profits comes from interest charges on unpaid balances. According to the Federal Reserve, the average credit card interest rate was 16.61% as of Q1 2020. Approximately 45% of credit cardholders carry a balance from month to month, which means they are paying interest on their outstanding balances. High-interest rates on these balances generate substantial revenue for credit card companies.

3. Fees

Credit card companies also profit from various fees, including late payment fees, annual fees, and over-limit fees. These fees can add up quickly and contribute significantly to the profitability of cashback programs. For example, cards with generous rewards programs often come with higher annual fees compared to those with lower or no rewards.

Psychological Incentives and Increased Spending

Cashback programs create a psychological incentive for consumers to spend more. The idea of earning money while spending encourages consumers to use their credit cards more frequently and for larger purchases. According to the Federal Reserve Bank of Boston, the average transaction amount with a non-cash transaction is nearly four times greater than with a cash transaction. This increased spending results in higher merchant fees and more opportunities for credit card companies to earn interest and fees.

The Fine Print: Managing Consumer Expectations

While cashback programs are marketed as generous, the fine print often reveals various limitations and conditions. For example, some cards only offer cashback on specific types of purchases, such as gas or dining, and may exclude certain transactions, such as those made with digital wallets. These restrictions help credit card companies limit the amount of cashback they pay out while still attracting consumers with the promise of rewards.

Cashback programs are a strategic tool used by credit card companies to increase their profitability. By leveraging merchant fees, interest charges, and various consumer fees, these companies can afford to offer attractive cashback rewards while still making a profit. The psychological incentives created by cashback programs also encourage increased spending, further boosting revenue. In essence, while consumers may benefit from cashback rewards, credit card companies are the ultimate winners in this equation.