Credit card rewards and freebies often appear to be generous gifts from issuers, offering cash back, points, airport lounge access, and other perks. However, research and analysis reveal that these benefits are not truly free. Instead, they are funded through a complex system of fees paid by merchants and, ultimately, by all consumers, whether they use credit cards or not. Understanding this funding mechanism is essential for U.S. consumers, deal seekers, and anyone interested in financial offers, as it clarifies the true cost behind seemingly lucrative rewards programs.
The Mechanics of Credit Card Rewards Funding
Every time a consumer swipes, taps, or inserts a credit card, a series of financial transactions occurs among multiple parties: the consumer, the merchant, the merchant’s bank (acquirer), the payment network (such as Visa, MasterCard, American Express, or Discover), and the card issuer (which may be a bank or, in some cases, the network itself). The merchant pays a fee to its acquirer for processing the transaction. This fee, known as a merchant fee or interchange fee, is a percentage of the purchase amount, typically ranging from 1.5% to 3% depending on the provider and transaction type.
Payment networks set these fees and determine the rewards structures for credit cards. Research from Kellogg School of Management indicates that networks use rewards to compete for consumers, funding these perks by increasing the fees charged to merchants. Merchants, in turn, pass these increased costs on to all consumers by raising prices across the board. This means that even consumers who pay with cash or debit cards effectively subsidize the rewards earned by credit card users.
How Credit Card Issuers Profit from Rewards Programs
Credit card issuers generate revenue from multiple sources, allowing them to offer rewards without losing money:
- Merchant Fees: Issuers share a portion of the merchant fees with consumers as cash back or points. The more a consumer uses their credit card, the more merchant fees the issuer collects, creating a cycle that incentivizes spending.
- Interest Charges: Many cardholders carry balances from month to month. According to the Federal Reserve, the average credit card interest rate was 16.61% in the first quarter of 2020, and approximately 45% of cardholders carry a balance. Interest on these balances is a major profit center for issuers.
- Late Fees and Other Charges: Issuers also profit from late fees, annual fees, and other penalties, especially when consumers miss payments or exceed credit limits.
Thus, rewards programs are designed to encourage frequent credit card use, which increases the likelihood that consumers will incur interest charges or fees, further boosting issuer profits.
The Hidden Costs for Merchants and Consumers
While credit card users may enjoy rewards, merchants face significant costs. They must absorb processing fees, which can cut into already tight profit margins. To offset these expenses, many merchants raise prices for all customers, regardless of payment method. This practice means that cash and debit card users are indirectly paying for credit card rewards through higher prices.
Businesses often accept card payments as a courtesy, knowing that 76% of consumers prefer businesses that accept cards and 58% are likely to spend more when using a card. However, the trade-off is the cost of processing fees, which range from 1.5% to 3% per transaction. Some payment processors, such as Helcim, use an interchange-plus pricing model, where merchants pay the base interchange fee plus a small markup (e.g., 0.4% plus 8 cents per in-person transaction for businesses with less than $50,000 in monthly card sales).
Freebies, Perks, and Unadvertised Benefits
Beyond traditional rewards, many credit card issuers and other organizations offer freebies and little-known perks to attract and retain customers. These can include on-the-house lattes at coffee shops, hotel suite upgrades, or even cash found in coat pockets. Such freebies are often part of loyalty programs, partnerships, or promotional campaigns.
Companies may partner with organizations such as AAA, USAA, or credit unions to reach millions of potential customers. Health insurance plans sometimes offer free or discounted items that promote healthy lifestyles, ultimately reducing medical costs. However, consumers are often unaware of these benefits because issuers and organizations do a poor job of communicating them. Free trials, in particular, can be risky: if not canceled on time, they may convert to paid subscriptions with monthly charges.
Marketing Tactics and Consumer Vulnerability
Credit card companies aggressively market rewards and freebies to attract new customers, especially young consumers and students. In the past, issuers gave out free gifts in exchange for completed credit card applications on college campuses. However, new regulations have banned this practice to protect students from being tempted into taking on credit they are not ready for. Card issuers must now disclose any marketing contracts they have with colleges, and applicants under 21 need a co-signer.
Despite these protections, many consumers do not read the fine print and may assume that cash back rewards are more generous or universal than they actually are. The promise of “free” money can be misleading, as the true cost is embedded in higher prices and fees paid by everyone.
Policy Implications and Consumer Protection
Research suggests that capping merchant fees and encouraging more debit-card usage could help reduce the hidden costs associated with credit card rewards. Such policies would make the market more efficient and lessen the burden on consumers and merchants alike. In the meantime, consumers should be aware that “free” rewards and perks are not truly free—they are paid for through a system of fees and higher prices.
Conclusion
Credit card rewards and freebies are funded by merchant fees and higher prices, affecting all consumers, not just cardholders. While these perks can be appealing, their true cost is embedded in the payment processing system. Consumers should approach rewards programs with a clear understanding of how they are funded and remain vigilant about hidden fees, trial offers, and marketing tactics. By recognizing the hidden costs, shoppers can make more informed financial decisions and avoid unnecessary expenses.