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In the first article of the series, we talked about how merchant’s pay higher fees to accept rewards credit cards. In the second article, we discovered you’ve really already (partially) paid for your “free” vacation through higher prices at the store. Now, we’re going to muddy the waters a bit, and talk about the other ways that the credit card companies will try to earn back the money they spent funding Jesse’s trip to New Zealand to play golf.
If you spend time accumulating points, you know that redeeming those points for travel is the ultimate goal. Once you go to redeem, you’ll quickly learn that no two redemptions are the same. For example, if you earn the sign up bonus for the Barclay Arrival Card (see our Top Offers > Airline & Travel menu) you’ll quickly find that getting the best bang for your buck (or points) isn’t so simple.
The credit card companies, issuing banks, and mileage programs are all hoping you spend your points on something that costs them less money. Because airlines, hotels, and other travel organizations are businesses (that intend to make money), the cost of fulfilling your points is less than the “retail value.” Really, that’s just the definition of a “business” phrased in a different way. The companies charge more than their costs, because they’re trying to make a profit.
Take an airline, for example. When you go to redeem your points, they’ll likely offer you a “saver” rate if you book a less popular flight, likely one where they expected to have any empty seat anyway. The cost of flying a plane with 105 people on board and 106 people on board isn’t much different. You can only drink so much free 7-up in flight.
If you try to book a spot on a popular route at a more popular time, you’ll likely need to book far in advance, as the airline intentionally limits the number of “reward seats” they’ll give away for points on popular flights. The airline is proactively managing your redemption opportunities to decrease the cost of accepting your points. It’s up to you to find the best redemptions, where you can get good value for your points and find the “sweet spots” in the airline’s reward program.
Buying Miles in Bulk
Consider the Citi American Airlines Platinum card. When Citi issues the credit card with a 50,000 AA mile bonus, they don’t go directly to www.AA.com and buy the miles for your sign-up bonus. They cut a deal with American Airlines ahead of time, and commit to buy millions of these miles in bulk. Because it’s guaranteed income for American Airlines (even if those points expire), they’ll sell points to Citi for a below-market rate (less than you’d pay). If getting you hooked into the loyalty program causes you to earn more American miles, and then fly only on American, even better!
Everyone has heard of them. In fact, some people swear off credit cards entirely because of them. Interest charges are the quickest way to sink a good bonus deal or rewards earning rate. The banks hope you carry a balance, and hope you pay interest on that balance. But, the question is, when they give you points, do they think you are going to carry a bigger balance because you’re earning reward points? In other words, are you more likely to be in debt on a rewards card than a normal credit card?
The answer is: it depends. Some banks are actively looking for customers that will carry balances, and expect to make most of their money in interest charges. They refer to these credit card users as “subprime” borrowers. Subprime borrowers tend to carry large balances, pay a lot of interest, and sometimes not pay the card off at all. Citi is a great example of a card issuer that targets these subprime customers . For 2015, Citi’s net interest revenue was about $27 billion, while their non-interest revenue (fees and other charges) was about $6 billion. They wrote off about $6 billion of loans that went bad.
Chase, on the other hand, had about $44 billion in net interest revenue, while their non-interest revenue was about $50 billion. They wrote off about $4 billion of loans that went bad.
The numbers aren’t perfect for talking about credit cards–all kinds of other things are included in them, like mortgages, business loans, and other banking services. But two things stand out:
- Chase’s income is balanced between interest on loans, and other sources (interchange fees, services, etc.) while Citi earns over 4 times as much from interest than everything else combined.
- Citi loans to subprime borrowers. In terms of loan losses, Citi’s bad loans represent more than 20% of their interest income, while Chase’s bad loans represent less than 10%.
Because riskier borrowers (read: lower credit scores) are charged higher interest rates, we can see a clear strategy here. Citi wants you to run up your balance and pay them interest. They hope you don’t default, but they know that’s part of the game when they charge high interest rates to risky borrowers. Chase want’s you to be a responsible borrower, occasionally paying interest, but also using their cards and banking services for your everyday financial life.
The truth is, there are hundreds of ways that banks make money. Interchange fees and interest income are two of the big ones for credit cards, but there are definitely others. Asking questions like: “Do they use the interest income or fee income to pay for rewards programs” is kind of irrelevant. Do you use Monday’s wages or Wednesday’s wages to pay your utility bills?
But, we can conclude that, while interest income is part of a bank’s overall profit picture, (along with other sources) interchange fees vary directly with rewards rates. So, those higher costs at the store are definitely helping pay for your travels.
So what are you waiting for? You’re already paying more at the grocery store, so go apply for some credit cards (Top Offers Menu), avoid carrying a balance, and start traveling the world for free!