Based on the number of Amazon packages I saw in my neighborhood, online shopping was a preferred method for most this holiday season, and the most common form of payment when doing online shopping is by credit card.
When used responsibly, credit cards and the rewards programs that come with them, are a favorite tool for savvy consumers to earn cash back, travel miles, and exclusive perks simply by spending. However, beneath the surface of these lucrative rewards offers lies an uncomfortable truth: those who carry credit card debt often subsidize the rewards enjoyed by those who pay off their balances in full each month. This system creates a divide between consumers and raises important questions about the true cost of rewards programs.
We know that creating meaningful experiences through spending on travel is very important to many of our clients. Zizzi Investments recently added a partnership with a credit card points expert, Colin Stroud, whose entire business is helping people smartly use their credit card points to book travel. We will be rolling out more details on this partnership to all Zizzi Investments clients in the new year.
First, let’s dive deeper into how credit card rewards work, the types of programs available, and the role of debt in funding these benefits.
THE MECHANICS OF CREDIT CARD REWARDS
At first glance, credit card rewards seem like a win-win for consumers. You spend money, earn points or cash back, and redeem those rewards for valuable perks. However, the system is far more intricate than it appears.
Here’s how credit card companies afford to provide these rewards.
Interchange Fees – Every time you swipe your credit card, merchants (businesses) pay an interchange fee—typically 1.5% to 3% of the transaction value. A portion of these fees funds rewards programs.
Interest Payments – Consumers who carry a balance month to month pay interest on their debt. Credit cards are a form of unsecured debt and carry very high Annual Percentage Rates (APRs) interest on that debt. Average credit card APRs range from 16% to 25% or even higher. The interest payments by those who don’t pay off their balance in full each month represent a significant revenue stream for credit card companies.
Fees and Penalties – Late fees, annual fees, and penalty interest rates also contribute to credit card companies’ profits. While merchants bear the interchange fee, they often pass this cost onto consumers through higher prices.
HOW DEBT SUBSIDIZES REWARDS PROGRAMS
Credit card rewards primarily benefit cardholders who avoid interest charges by paying their balances in full every month. These consumers are essentially receiving perks for free, funded by those in debt that offset the cost of the rewards programs for the credit card companies.
While the cost of these rewards programs is significant for credit card companies, it still pales in comparison to the profits credit card companies make through collecting interest and processing fees.
TYPES OF CREDIT CARD REWARDS PROGRAMS
Credit card reward programs are as diverse as the consumers they target. It seems nowadays, almost any store you walk into is offering their own branded credit card card and a “discount” for using it.
Here’s a closer look at the three most common types:
1) Cash Back Rewards
How It Works – Cardholders earn a percentage of their spending back as cash, usually ranging from 1% to 5% depending on the card and spending category.
Who Benefits – Cash back cards appeal to everyday spenders who prefer simple, tangible rewards. These cards are particularly popular among those who value flexibility, as the cash can often be applied as a statement credit or direct deposit more gradual with future rate cuts.
Hidden Costs – Higher interest rates often accompany generous cash-back rewards, making it crucial to pay off the balance in full to truly benefit.
2) Low APR and Balance Transfer Cards
How It Works – Instead of offering traditional rewards, these cards focus on low interest rates or promotional 0% APR periods for balance transfers and purchases.
Who Benefits – Consumers looking to consolidate debt or finance large purchases without incurring high interest charges. These cards are ideal for those who prioritize saving on interest over earning rewards.
Hidden Costs – The lack of traditional rewards means these cards may not offer the same long-term benefits once the promotional period ends.
3) Points and Travel Rewards
How It Works – Cardholders earn points or miles that can be redeemed for flights, hotel stays, and other travel-related expenses. Some cards also offer travel perks like lounge access, travel insurance, and no foreign transaction fees.
Who Benefits – Frequent travelers who can take full advantage of these rewards reap the most value. However, many travel cards have annual fees, which can cut into the value of rewards if not used strategically.
Hidden Costs – These cards often encourage spending to meet high bonus thresholds, leading to potential overspending or, worse, carrying a balance with interest.
MAXIMIZING REWARDS WITHOUT FALLING INTO DEBT
While credit card rewards can be incredibly valuable, they are only beneficial if used responsibly. Here are some tips to ensure you’re getting the most out of your rewards without falling into debt.
Pay Your Balance in Full – Avoid carrying a balance to eliminate interest charges, which can quickly erase the value of rewards. Unless specifically utilizing a 0% or low APR card for a time period, it is typically best to pay off outstanding balances monthly to avoid accruing interest.
Choose a Card That Matches Your Spending – Select a card with rewards aligned to your spending habits, whether that’s groceries, travel, or dining.
Avoid Overspending – Stick to your budget and avoid spending more just to earn rewards.
FINAL THOUGHTS
Credit card rewards programs are enticing, but they come with hidden costs that disproportionately affect those who carry debt. Using credit cards responsibility can help maximize rewards without falling into the trap of subsidizing someone else’s perks.
Remember, credit cards are tools. Use them wisely, and they can work for you. Misuse them, and you risk becoming the one who pays for someone else’s free vacation.
Happy New Year to all!
