How do Credit Card Rewards Work?

Credit cards are one of the most important financial tools you have at your disposal. They can either make your financial life or break it. If you know how to work the system and pay off credit cards each month, certain cards can actually make you money when you spend with them.All of that sounds a little weird though when you think about it. How can a company offer you, say, $500 when you sign up for the card and spend money? Or how can credit card companies give you 2% cashback on all purchases?Obviously, the money has to be coming from somewhere, so how are banks getting all that cash to keep up with those rewards? There are 3 different ways.

Revenue sources

Credit card companies bring in revenue from 3 sources:

  • Interest
  • Fees
  • Interchange Fees

Interest and often fees are pretty standard on credit cards. If you use a credit card and don’t pay off the full balance by the due date, the issuer will start charging interest on the money left over, usually something crazy like 25 to 30%. For reference, a typical auto loan or mortgage falls in the 3-4% interest rate range.

But we all understand interest on credit cards, that’s standard on cards whether they have rewards or not.

Some cards with rewards also charge you fees each year to hold the card. These can be a way to trick you into paying for the rewards you think you’re getting.

All that said though, some cards don’t have fees and for people who really take charge in their credit life, they pay off their cards every month and never get charged interest. So, for people who never pay interest and have cards without fees, how do companies not lose money on these people?

Interchange fees. 

For the cardholder, if you fall into this group of people, credit card rewards are basically free money. Interchange fees are the fees paid by the store or seller you purchase something from. It’s usually a 1 to 3% flat fee on any purchase that a retailer pays directly to the card company. In the merchant and card companies eyes, this is a fee charged for the convenience of being able to accept the payment.

These interchange fees will vary based on cards, so a credit card with high rewards might have a high interchange fee to cover costs for the card company.

What ends up happening here is that merchants bake these fees into their prices, so in many cases, buying something with a credit card that has rewards is actually better than straight-up cash (as long as you’re responsible and pay off the card).

But if stores have to pay all these high fees, why don’t they just refuse to accept the card? Well, for the most part, they get strongarmed by the credit card companies into accepting the fees so that the merchant has the ability to process say, all Visa cards. For many stores, if they don’t accept credit, they would lose a lot of business from customers.

The Way Issuers Make Money

When it comes down to actual dollars and cents, the way card issuers make money on credit rewards isn’t so cut and dry. In certain cases, they’ll offer up cards with something like 5% rewards on certain purchases. In these cases, they would be losing money between the interchange fees. These cards are great for people who are responsible with their credit, and by setting the rewards so high, the company hopes to attract enough people to make their money back in interest from unresponsible consumers.

What does this mean for you?

So, if you want to fully take advantage of credit card rewards and earn that free cash, here’s what you need to do:

  1. Pay off your cards each month. Don’t lose that free cash by having to pay insane interest on what you spent.
  2. Get a rewards card that doesn’t have a fee. Typically you’d only want a credit card that has fees if the rewards you’re getting out of the card are really worth it to you. In these cases, don’t view the rewards as “free”, but rather think of them in terms of costing whatever the fee on the card is.
  3. Get sign-up bonuses. Getting sign-up bonuses for cards are usually the most lucrative ways to earn rewards. Many cards offer upwards of $1000 if you spend a certain amount on the card in a given amount of time. If your budget already has you spending the required amount of money to get the reward, just get the card, move your spending to the card for several months, and get the free money. If you don’t spend enough, then it’s probably best just to find a rewards card that fits within your budget.
Trevor is a civil engineer (B.S.) by trade and an accomplished writer with a passion for inspiring everyone with new and exciting technologies. He is also a published children’s book author and the producer for the YouTube channel Concerning Reality.

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