Credit card rewards can feel super fun. Buying new stuff and spending money is exciting, and if you get presents for doing so, what’s not to like? Credit card companies are well aware of the allure for consumers — rewards are a good way to get people in the door and try to keep them loyal.
What many consumers don’t like to think about are the trade-offs they make when they sign up for rewards cards; after all, your points and miles and cash back aren’t gifts from the sky for being special. Rewards can come at a hidden cost, often to lower-income consumers and people who pay in cash after merchants, who pay higher swipe fees for fancier cards, pass on extra expenses. But rewards cards also come at a cost for people who, to put it plainly, aren’t very good at using them. With all the websites dedicated to the ways to game the credit card system, it’s easy to overlook all the ways that, if you’re not careful, the system is gaming you.
Rewards cards are only really useful for consumers who are generally credit-savvy. Less financially sophisticated consumers — meaning people with higher unpaid balances or who don’t pay off their cards month to month — ultimately end up losing out. They wind up subsidizing the rewards of people who are a little better at credit, wherever they fall on the income spectrum. More than half of credit card customers are “revolvers,” meaning they don’t pay off their full balances each month.
“Financial literacy matters a lot,” said Andrea Presbitero, senior economist in the research department of the International Monetary Fund and one of the authors of a 2022 paper looking at rewards and redistribution in the credit market. “Unsophisticated people, naive people, make a lot of financial mistakes.”
The kicker: To banks, it really doesn’t matter whether a rewards customer is particularly good at managing their personal finances or not. They make money either way. Let’s break down what Presbitero and his colleagues found.
If you can’t pay off your balance, you might be paying for the rewards of someone who can
Rewards cards are a booming business for issuers and popular among consumers across the credit spectrum. According to the Consumer Financial Protection Bureau’s 2021 consumer credit card market report, even people with “deep subprime scores” — meaning very low credit ratings — put over 60 percent of their credit card purchase volumes on rewards cards, and almost three-quarters of near-prime consumers did the same. The highest-credit consumers are the biggest rewards power spenders. (If you need a full explainer on the United States’ credit score system, you can find one here.)
How much bang people are getting for their buck, if any, really shifts across the credit spectrum, according to Presbitero and his colleagues’ research. They found that people with super-prime credit (those who have a FICO score of 780-850, the upper limit) on average earn $9.50 in rewards and pay $7.10 less in interest each month on rewards cards compared to run-of-the-mill classic cards. Subprime consumers, meaning people with credit scores below 660, earn just $1.80 in rewards and pay $6.40 more in interest. “We estimate an aggregate annual redistribution of $15 billion from less to more educated, poorer to richer, and high to low minority areas, widening existing disparities,” their report reads.
The researchers looked at two specific areas where what they call “naive” consumers make more mistakes with rewards cards: they overborrow, and they don’t pay their credit card debt in an ideal way. They focused on rewards cards that offer points, miles, or cash back for dollars spent; the data did not contemplate perks such as airport lounge access.
On the first front, they took a look at bank-initiated credit limit increases on rewards cards, meaning instances when the bank says something like, “Hey, here’s an extra $1,000 on your credit limit, go nuts.” They found that such increases led to higher unpaid balances among consumers with low credit scores — they upped their spending because they could, but they weren’t able to up their ability to pay that debt back.
“If you’re an unsophisticated guy, you get this $1,000 more, you increase your consumption and your spending, but you are not able to increase your repayments because you are constrained,” Presbitero said. “You end up with unpaid balances, and on those balances, you’re going to pay interest rates and charges. So, yes, maybe you’ll get like $2 in rewards, but then you have to pay $5 in interest.”
On the second front, the researchers examined people with multiple cards at the same bank and looked at how consumers addressed their different debts. They found that low-credit consumers “tend to follow a sub-optimal (and costly) balance-matching heuristic when repaying their credit cards,” meaning they didn’t pay down their cards in the best ways. For example, they focused too much on cards with higher balances and not cards with higher interest rates, where the debt would ultimately be more costly.
Presbitero said that the issue isn’t necessarily that certain consumers don’t know how to best approach paying down debts and handling their rewards cards, it may just be that it doesn’t really matter to them, or they’re not paying attention. “They may be so rich that they don’t care,” he said. “It could be that you are unsophisticated and you don’t know, or it could simply be because of what economists call rational inattention; it’s rational for you not to pay attention.”
Whatever the case, when people screw up with rewards cards, they pay a price — and that price ultimately helps pay for the rewards of people who don’t.
On an aggregate level, this has a geographic impact. Presbitero and his colleagues note that, on net, average rewards are higher in zip codes with higher education levels, higher average income, and a lower share of Black residents.
The bank wins regardless
Thinking about where credit card rewards come from can be uncomfortable. Yes, they are nice when you get them, but they’re not inevitable or really necessary. It’s a little awkward that consumers are offered a prize for the act of engaging in capitalism, and one where there are fairly significant trade-offs, on net, among consumers, merchants, and other stakeholders.
The important thing to keep in mind here is that credit card companies and banks are in the business of making money, and they would not be handing out rewards cards if there were not something in it for them. In this case, there are billions of dollars on the line.
Issuers make money on rewards cards holders regardless, across the credit spectrum. The researchers found that banks profit most from near-prime and prime consumers in the middle of the FICO score distribution. At the high end and the low end of the FICO range, the ways banks make money differ. For subprime consumers, over 60 percent of banks’ revenue on rewards cards comes from interest income. For super-prime consumers, more than 80 percent is from interchange income, meaning the swipe fees merchants pay when people spend. In the middle, banks can make money on both interest charges and swipe fees.
“The bank is clearly the winning player here,” Presbitero said. “Regardless of my behavior, if I’m a revolver or not, if I spend less or a lot, the bank always makes money.”