Credit Card Victims Don’t Pay for 100% of My Credit Card Rewards

by Kevin on September 18, 2008

I got an interesting comment on my post titled “I Like Dave Ramsey, But He Is Still Wrong“. This is from Troy:

Credit Cards exist for solely one reason. PROFIT. Not convenience, points, fraud protection, etc. Those are benefits, not purpose. The purpose is profit for the issuer. That means that a majority of users must result in a profit for the issuer, and a cost for the user.

Obviosly you already know this. that is why there are rewards and benefits, etc. It is redistribution. Most people pay, so a few can benefit, yet most think they are or will be the ones who benefit, but of course the economic model will not support that.

CC are tools, just not for the user. they are tools for the issuer, and they are unnecessary. You can accomplish the exact same thing, with the same benefits, convenience, fraud protections with a debit card, so the only reason for CC is credit, and the incorrect assumption that using one is in your benefit because you can “beat” the system.

The issuer set up the system. It is their rules. Their money. their card with their name on it. They have the control, not you. They just let you think you do.

First, I want to make sure I thank Troy for his comment and furthering the discussion in a civil manner. We can all agree to disagree, right?

The credit card nay-sayers who disagree with my stance on credit card rewards like to say that it is essentially a redistribution of wealth. The argument is that a majority of folks out there are paying ridiculous fees and interest charges and the minority get the rewards from this vast amount of money the firm earns from the “victims”.

Let’s run some math here using my American Express Blue Cash credit card.

The cash back rewards program is setup like this: up to $6,500 of total charges for the year I earn 0.5% on general purchases and 1.0% back on “bonus” purchases. Bonus purchases include grocery stores, drug stores, and gas stations.

After $6,500 in total spending the rewards jump to 1.5% on general purchases and 5.0% on bonus purchases.

Let’s assume you charge $1,000 per month on your credit card. The credit card has a 2.50% discount rate for the merchant. A discount rate is what the card company charges the merchant (grocery store) to process the card. So if I spend $1,000 per month and the discount rate is a consistent 2.50% the revenue to the company is $25 for that month.

Let’s also assume I split my charges an even 50/50 — half general purchases and half bonus purchases. Each line below is one month. So line two where it says cumulative charges is 2 months worth of charges.

Definitions:

  • Merchant Cost: what the merchants would pay to American Express
  • Total Charges: Total amount of charges put on the card
  • Cumulative Charges: rolling total of all of the monthly charges — but not holding a cumulative balance. That is, paying off the balance at the end of the month with easy, automatic payments. Resulting in no interest or fees.
  • General/Bonus Charges: 50/50 split of the total charges for each month results in $500 in each category.
  • General/Bonus Rewards: based on the total amount of spending (under or over $6,500) the amount of rewards that would be given based off of the $500 in general and $500 in bonus charges. After $6,500 (middle of the 7th month) the rewards jump up.

Merchant

Cost

Total Charges Cumulative

Charges

General

Charges

Bonus

Charges

General

Rewards

Bonus

Rewards

25 1,000 1,000 500 500 2.50 7.50
25 1,000 2,000 500 500 2.50 7.50
25 1,000 3,000 500 500 2.50 7.50
25 1,000 4,000 500 500 2.50 7.50
25 1,000 5,000 500 500 2.50 7.50
25 1,000 6,000* 500 500 2.50 7.50
25 1,000 7,000 500 500 5.00 15.00
25 1,000 8,000 500 500 7.50 25.00
25 1,000 9,000 500 500 7.50 25.00
25 1,000 10,000 500 500 7.50 25.00
25 1,000 11,000 500 500 7.50 25.00
25 1,000 12,000 500 500 7.50 25.00
300 12,000 6000 6000 57.50 185.00
242.50

* = in the middle of the 7th month the rewards change after $6,500 in spending is reached. I split that month in half — $250 for each category for the first half of the month, and $250 for each category in the second half of the month.

So let’s look at the result. The merchant would end up paying $300 to American Express. That’s a business expense and I’m sure they wish it were less, but you don’t see many stores not accepting credit cards these days. It’s the cost of doing business.

The total amount of rewards is $242.50 for the year. You can see the breakdown above. With total revenue from the merchant of $300, that leaves $57.50 for American Express. At the end of the day the total merchant costs from my spending can pay for the rewards I earn.

Some Additional Points:

  • For the average person they are going to have more general purchases than a 50/50 split. I would guess it is more like 70% general/30% bonus because big stores that sell groceries and fuel (WalMart) don’t count as bonus purchases. Restaurants don’t count as bonus purchases. This means less rewards paid out and thus more margin for American Express than the above example.
  • Some of you will say that $57.50 is not enough profit for American Express, so they must be taking advantage of someone else. This is just an example to show that my rewards aren’t necessarily coming from other user’s interest charges. I also think AMEX’s merchant charge is higher than 2.50%, but I can’t find verifiable information on that.
  • Some of you will say they also earn a ton of money from interest charges and fees from people who carry a balance. I’m not discounting that. It’s true. If you borrow money from the bank and don’t pay it back immediately, you pay interest. That’s the problem with carrying a balance. But the idea that the people who get “screwed” with credit card interest are financing my cash back isn’t 100% accurate. The merchant costs can pay for the cash back fairly easily.
  • What if more of my spending was in the bonus category? Then I suppose it might not break-even with the merchant costs. Then again, if I only spend $500 per month on bonus items and $0 on general items then it is going to take a long time to get to the tier limit ($6,500) where the really good cash back kicks in. The $500 in spending would result in $12.50 in merchant costs, and in the first tier only $7.50 in rewards. Still covering the cost of the rewards at that point.
  • Some of you may also say I am just creating this example so I won’t feel guilty about other people paying interest to American Express so I have rewards. While I wish they wouldn’t pay interest (kind of the purpose of this blog!), I am all for personal responsibility. No one is holding a gun to their heads to make them swipe the card.

So let’s hear it. Do you agree? Disagree? See some glaring issue with my assumptions? Remember, let’s keep it civil in the comments.

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