Have you ever gotten a free flight because of your Delta
SkyMiles card? Or maybe a near impossible restaurant
reservation thanks to your platinum American Express card?
What about that five minute TSA PreCheck line, a perk of your
Capital One Venture rewards card. And of course, we can't
forget about that airport lounge access because of your Chase
Sapphire reserve card. About 90% of all money spent on credit
cards is on rewards cards.
We have created an ecosystem where we have essentially been
given a drug to the consumer, which is these rewards cards.
And the reason we keep giving this drug as we know it's highly
profitable, and we know the consumer is addicted to it.
If you play the game right and maximize your rewards, you could
save at least a few hundred dollars every year. But every
time you pay for something with a credit card, you're borrowing
money from the card issuer to cover your purchase money you
have to pay back either in full at the end of the month, or over
time. If the latter, that's with interest accumulated. While
there are some Americans winning on these cards, meaning they
might be reeling in points, cashback and free subscriptions
left and right. Others are losing money, paying more in
interest than they're getting in perks.
We have alerts that alert customers to when their payments
are due. We're very, very committed to the idea of our
customers using credit responsibly paying on time, and
having that credit card help them grow their credit profile.
Credit
card companies should take some level of responsibility card
companies must educate the consumer.
Nonetheless, Americans have debt - a lot of it. So we decided to
take a deeper look to see who's winning versus who's losing on
these rewards cards. Because experts say there's a pattern.
In 2019, the largest US banks reported $9.9 billion in fee
income, $89.7 billion in interest income, and $41.3
billion from interchange fees on credit cards. That's a total of
more than $140 billion in revenue from credit cards alone.
According to experts, more than half of that comes from rewards
cards.
It's hugely profitable. People who use reward cards, they tend
to spend more and they tend to have more debt on their reward
cards and they tend to default more.
Let's go through the three revenue sources. When we talk
about fees, we’re referring to annual, foreign transaction,
late and over-the-limit fees. Americans with higher credit
scores are typically paying more in annual and foreign
transaction fees as they’re using more premium cards with
higher annual fees and travel internationally more. Meanwhile
those with lower credit scores are more likely to be hit with
late and over-the-limit fees as they’re less likely to have the
cash to pay their balances on time. Interest is the price
you pay to borrow money. For credit cards, that’s the annual
percentage rate or APR. As of early 2023, the average APR for
credit cards is about 21% — marking the highest rate since
the Fed started tracking this nearly three decades ago. As for
the top rated rewards cards – the APRs can range from around
17 to 30 percent. Now who’s paying that? It’s generally
low-income households because they’re more likely to carry
credit card debt month to month. They also typically have higher
APRs - as they have lower credit scores. As for interchange,
sometimes referred to as swipe fees…. those are typically
invisible to the consumer. Everytime a retailer processes a
credit card payment, the merchant pays an interchange fee
to cover the costs associated with accepting, processing, and
authorizing the transaction. Merchants pay more than 120
billion dollars each year to accept cards. Business owners
set prices with that in mind. Some - with the goal of passing
part of that cost onto the consumer. That means higher
prices overall for those who are wealthy, have lower-incomes and
those who don't even have credit cards… and don't reap the
benefits of them. It is
unfair, but it's something that you know, people who are in
underserved communities or impoverished communities have
dealt with all the time.
As the cost of living rises, Americans are relying more on
credit cards, credit cards accounted for 32% of in person
payments in 2021, up from 20% in 2016. Whether it's Jennifer
Garner, asking "what's in your wallet?" or your friend bragging
that their flights were free because they use points, rewards
credit cards are everywhere, and hugely popular. In 2019 and 2020
about 90% of all money spent on credit cards was on rewards
cards. The purpose, of course, is to get those perks.
The way you get rewards is you gotta use it a lot. Because the
more you spend, the more you get.
We tend to think that all customers can benefit from a
rewards card. Regardless of their circumstance. Let's take
the popular Chase Freedom unlimited card for example.
Consumers love this card because it has no annual fee, 1.5 to 5%
cashback and no APR, but only for the first 15 months. So
let's say you get this card. If at any point in time after month
15, you don't pay your balance in full, your APR could be as
high as 29%, your penalty APR for a late payment, nearly 30%.
Just the math will not add up. The rewards cannot be 18% The
rewards are only one or 2% of all the purchase. Whereas for
every dollar you purchase, if you get a reward of 1%, you're
paying 18% interest on
it. I would guess refute the notion that they're losing
money. The fact is, there are any number of reasons why
somebody may choose to carry a balance. In some instances, it's
convenience. In some instances, it's cashflow in some instances,
it may be circumstances where you know they have short term
liquidity needs that credit cards address the idea of a
carrying a balance is separate and apart from the benefits of
earning rewards.
Avoiding debt to make your rewards card worthwhile is
certainly a good strategy. But the reality is, Americans have a
lot of debt - credit cards are one of the largest sources of
consumer debt. On average, Americans carry $6,194 in credit
card debt. In 2023, the Consumer Financial Protection Bureau
estimated that outstanding credit card debt may continue to
set records and can even hit $1 trillion.
The bank's goal is twofold one is to go for you to go out and
spend as soon as you spend, they make money because of the
interchange fee. The second goal is for you to carry debt. Now
they realize invariably the rich don't carry much debt is the
poor who carry a lot of debt. Because their liquidity
constraints they don't have enough money so they rather give
it to the poor people or the low FICO score people the reward
cards.
Sumit Agarwal is an economist who has studied credit cards for
more than 20 years. Using data from a large US financial
institution. He along with others analyzed how consumers
change their spending habits on credit cards in order to get
cash back. They claim credit card rewards incentivize
subprime and near prime consumers to overspend and
overborrow on their cards. That's consumers who have credit
scores ranging from 580 to 619, and 620 to 659, respectively.
And data from the Federal Reserve Bank of New York
supports that showing that low-income card holders have
higher delinquencies and higher median balances and collections.
They also have a much larger debt to income ratio with their
credit card debt accounting for more than 26% of their total
income. In comparison, Americans with much higher incomes, their
debt accounts for only 4% of their income on average.
While rewards are great, I mean, who doesn't love a free flight
or nights at a five star hotel in the Caribbean, right? But not
everyone is getting to the point where flights are actually free.
So the question is, do these cards pay off for everyone?
Super-prime card holders are those with credit scores of 720
and higher, earn on average $9.50 In rewards and pay $7.10
less in interest on rewards cards than on classic cards.
However, subprime consumers are those with lower credit scores
on only $1.80 in rewards and pay $6.40 more in interest. That
means card holders who rank highly on a credit score model
like FICO, on average, earn money with the use of rewards
cards. While low FICO card holders on average lose money,
they tend to spend more have more debt on their rewards cards
and default more.
The rewards card kills me because they they're encouraging
them to have bad behavior to use it and use it and use it so they
get more rewards. And at the end of the day, the problem is not
paying it off every month, the poor keep getting poorer and the
rich keep getting richer.
Low FICO customers are essentially spending so much
reeling in the rewards. Agarwal and his co authors estimate an
annual redistribution of more than $15 billion from less to
more to get access to the rewards, which is only 2% or 3%
more educated, poorer to richer and high to low minority areas,
widening existing disparities. That means they're claiming
there's $15 billion that could be distributed in a different
way to achieve greater equality.
of the total value of the spending. They accumulate debt
and that debt accumulation causes this huge interest
payment that is going to the bank. And it's also going to the
high FICO score customers because these high FICO score
customers are only using these rewards but not accumulating any
debt. So they are being cross subsidized in the process of
using their reward cards.
Rewards are not funded by interest or other fees. While
there are certainly customers who choose to borrow on their
credit cards that is not typically the revenue streams
that are funding rewards cards. And so I think the premise and
the flawed premise behind this study was that those who are
carrying balances and therefore paying in interest are actually
cross subsidizing or contributing to the
profitability of rewards programs overall, that is
actually not the case. Our rewards products are designed to
be independently profitable. And so those customers even those
that pay in their balances in full every single month, are
profitable and desirable customers for Capital One and
other issuers across the industry. But you also have
other customers who may borrow on their credit cards and
therefore pay interest and that contributes to the economics of
those products. But those are separate and apart from one
another. There's no cross subsidization that goes on.
Agarwal and his co authors are not the first, nor are they the
only economists to make these claims. A 2010 research paper
states on average, and after accounting for rewards paid to
households by banks, the lowest income household pays $21 and
the highest income household receives $750 every year.
According to Capital One Bank in 2022 $7.6 billion was handed to
customers and rewards the bank says that's covered by
interchange fee revenue alone. However, the company didn't
share how much it brings in from fees and interest on rewards
cards.
Each one of our credit cards is designed to be profitable and
not to rely on cross subsidization from other
products. The vast majority of our rewards customers pay in
full every month, so don't actually pay any interest, or
other fees. And so it's really the interchange fee revenue, the
annual fees and then relationships with co-brands
that fund the cards. In its
2022 10k report, Capital One's net interest income for all
credit cards was nearly three times its non interest income.
In addition, net interest income increased by $2.5 billion in
2022 from 2021 - the bank saying that was primarily driven by
higher average loan balances. While the credit card business
is hugely profitable for a bank, serving a wide range of
customers is also risky. Capital One's provision for credit
losses, or the company's estimate of how much it might
lose due to credit risk was nearly $4.3 billion in 2020,
that's about 19% of total revenue. Do you think that banks
would continue to offer the same rewards the same perks that
they're currently offering if they weren't getting the
interest that they're currently getting?
I think any banker will have a hard time considering this
scenario, because it's impossible to think about credit
cards without interest. They're there. It's a lending business
and finance charges as part of the lending business.
While when played right,
the credit card rewards game can be beneficial for some and a
slippery slope for others, there are Americans who are using
credit cards for a different kind of perk, one that's not
considered a "reward" - purchasing power. The reason
why I made it out of the barrio and my parents were immigrants
from Mexico made it out was because they learned how to
leverage debt, and they borrowed money.
But the thing is, if consumers are going to borrow, they need
to do it right. As of 2023, Americans owe nearly $1 trillion
in credit card debt, with more than half living paycheck to
paycheck.
Most of my clients that are in the survival or the struggle
stage, they're they're working two jobs, they've got kids,
they've got a family, they're not taking the time to sit down
and read the Wall Street Journal, they're not reading the
Economist, they're not seeing what's going on and how certain
things are affecting them. When I'm working with somebody who's
struggling, I want them to have a credit card, I just need to
educate them on how to use it responsibly.
Louis Barajas says rewards cards aren't the best option for some
people. In fact, for those who can't pay their balances each
month, many CFPs recommend staying away from most credit
cards. However, it's a catch 22 - you can't get better credit
cards or borrow money without a good credit score. And you can't
get a better credit score without building your credit.
That's where secured credit cards come in.
So you have a savings account where you'll deposit 500 bucks
or 300 bucks or whatever credit limit they're gonna give you and
you use that but the bank knows that you have money that cover
that up to that amount as as you become responsible and using
that credit card, then the limit goes higher and it goes higher
and go higher, and then you start building up your credit
score. That's the best way to do it. We just need to teach people
how to be proactive and how to defend themselves and how to ask
the right questions.
Lack of financial literacy is an ongoing problem in America.
While more education is needed, according to researchers, banks
aren't completely innocent.
Look, ultimately the consumers are making the mistake of using
these cards. There was no gun put to the head of the consumer
who is poor has a reward card go spend on it, they spend out of
their free will but at the same time the banks know that what
they are doing, they are trying to entice the consumer to go out
and spend.
We are firm believers in financial education and making
sure that our customers are informed about the benefits and
the risks of using credit cards.
Would you recommend that all Americans get a rewards credit
card regardless of where they live in the country, regardless
of their income?
Yes, I think that the if you're going to get a credit card, and
you can qualify for a rewards card, you should absolutely do
it.
Experts say legislation could make a difference too. In 2010,
the federal government and 17 states sued the major credit
card companies for prohibiting merchants from incentivizing
customers to use cards that charged lower swipe fees. But in
2018, the Supreme Court upheld the companies' right to do so -
a setback in the fight for equality within the American
payment system. Meanwhile, the Credit Card Competition Act was
introduced in both chambers of Congress in 2022. The
legislation would require credit cards issued by the country's
largest banks to be processed through at least two different
networks. According to an analysis by CMSPI, it could save
merchants and their customers $11 billion a year.
We're definitely opposed to this legislation, which we believe is
in inappropriate price control.
So are there other solutions to evening the playing field?
CFPB has made regulation like the card act that was hugely
successful because they said we will eliminate over limit fees
so you cannot go over limit on your credit card. Similarly,
they could come up with regulation that will say that if
you are giving rewards card that rewards card, interest income,
or interest rates that you can charge has to be capped at a
certain number. I could also say the banks could do it
voluntarily. But I don't have much hope on that.
What do you think the credit card rewards business would look
like if all of the consumers of rewards credit cards were highly
financially sophisticated?
I think you'd see a significant erosion in the value of rewards.
If you're competing among a smaller, well educated customer
segment, your customers would more naturally identify the
"winner" when it comes to the math if they're all
sophisticated and are absolutely 100% optimizing payment days and
the costs would shift away from rewards to capture the volume
from that sophisticated customer segment.
But doesn't that then mean that the banks need less
sophisticated individuals to participate in this business in
order for it to be so profitable that they can continue to offer
such great rewards?
100% yes, they need unsophisticated customers - high
credit scores, medium credit scores and low credit scores.
Absolutely. If everyone made the rationally correct decision at
every point, the banking industry in the US would, would
probably not exist.