Credit Card Rewards: Who Really Pays?

How credit card reward programmes are funded by merchant fees and interest, and why they can transfer money from some shoppers to others.

Credit cards often offer rewards: cashback, air miles, points and discounts. They can feel like free money. But rewards have to be paid for by someone.

How rewards are funded

Merchant fees: when you pay by card, the shop pays a fee, often a percentage of the sale. A large part of this, called the interchange fee, goes to the bank that issued your card. Banks use this income to fund rewards.
Interest: cardholders who carry a balance pay high interest rates, often over 30 percent a year in India. This interest is a major source of card profits.
Annual and late fees.

The hidden cross-subsidy

Shops usually set a single price for all customers, whether they pay by cash, debit card, UPI or a rewards credit card. To cover card fees, prices may be slightly higher for everyone. This means customers who pay with cash or low-fee methods help fund the rewards of those using premium credit cards.

Research by economists at the Federal Reserve Bank of Boston estimated that this system transfers money from cash-using households, who tend to have lower incomes, to credit card users, who tend to have higher incomes.

Getting value from rewards

Rewards can be genuinely valuable for people who:

Pay their full balance every month, so they never pay interest.
Would spend the money anyway.
Choose a card that matches their spending.

For people who carry balances, interest usually far outweighs any rewards.

Rewards versus interest

A cardholder earns 2 percent cashback on 20,000 rupees of monthly spending, receiving 400 rupees. But if they carry a balance of 50,000 rupees at around 3 percent interest a month, they pay about 1,500 rupees in interest. The rewards are dwarfed by the cost of borrowing.

India’s context

In India, UPI payments have no merchant fees for most transactions, making them cheap for shops. Credit cards, however, carry merchant fees, which is one reason some small shops prefer UPI or cash.

Thinking rewards make spending cheaper

Rewards only make purchases cheaper if you pay your balance in full and would have bought the items anyway. Spending more to earn points, or carrying a balance, usually costs far more than the rewards are worth.

Key takeaways

Card rewards are funded by merchant fees, interest and card fees.
Uniform shop prices mean cash users can partly fund card users' rewards.
Rewards benefit people who pay in full and spend as they would anyway.
Interest on carried balances usually outweighs any rewards.