Business is booming.

Who really pays for your rewards?

Andrea Presbitero is a senior economist in the research department of the IMF. The views expressed herein are those of the author and should not be attributed to the IMF, its executive board, or its management.

If you live in the US, it is likely that when you eat out, buy groceries, travel — or subscribe to the FT — you pay with a reward credit card. The reason is simple: reward cards give you back money anytime you use them, either directly, in the case of cashbacks, or indirectly, with miles and points which can be redeemed at airlines, hotels, or selected retailers.

The market for reward cards is booming in the US, where banks paid $35bn in rewards in 2019, and it is expanding elsewhere, including in Europe. As banks generally charge lower interest rates (APRs) on rewards than on traditional cards, switching from a traditional card to one with rewards should offer a net gain for consumers. Is this true?

Often, the answer is no. The main reason is that people tend to focus on immediate benefits while ignoring the costs, as they materialise only later and are not easy to quantify. Knowing that people are subject to behavioural biases and have limited self-control, banks design and advertise reward cards with promotional low (or even zero) APRs and large sign-up bonuses. This gives consumers a strong incentive to spend to accumulate cashback and points.

Some individuals can get the most out of their cards, picking the right one for each type of purchase, to maximise points, miles and cash back. And making sure to always repay their balances at the end of the month. But not everyone manages this. For many, being able to access cheap credit risks to end up in excessive borrowing and debt distress.

In a recent analysis of supervisory data on the quasi-universe of US credit cards, we show that this is indeed the case. Only a fraction of credit cards earn positive rewards, once you factor in the fees and the interest charges that people pay any time they do not repay their balance in full at the end of the month. With promotional zero interest rates on balances and high reward rates, people have strong incentive to spend, even beyond their means.

This is more common than you think, since borrowing looks very cheap. But once the promotional period ends and the “real” APR kicks in, being a revolver — meaning using a credit card to borrow — becomes very expensive (the average APR is about 18 per cent) and can offset the rewards, leading to net losses.

So while some people can gain from reward cards, others lose money — and not a trivial amount. But who are the winners and losers?

Before we get into the numbers, let’s briefly talk terminology. Financial “sophistication” is a measure of the propensity to make financial mistakes. Its opposite is “naïveté”. In our analysis we take the individual credit score — the FICO — as a metric of financial sophistication, so that low-FICO individuals (subprime and near-prime consumers) are considered “naive”, while high FICO ones (prime and super-prime) are considered sophisticated. The likelihood of making financial mistakes is indeed higher for people with lower FICO scores.

Reward programs are often framed as a “reverse Robin Hood” mechanism in which the poor pay for credit card points, miles, and cash back enjoyed by the rich. However, this explanation is, at best, incomplete. Instead, reward cards primarily redistribute benefits from naive consumers to sophisticated ones.

This can be seen looking at the following chart, which plots the net rewards on each card (ie the difference between the rewards and the fees plus interest charges) against the cardholder’s credit score, which can be considered a measure of financial sophistication.

his figure illustrates the dollar magnitude of average net rewards across the FICO distribution, separately for reward cards (solid red line) and classic cards (dashed blue line). For each card type, the chart plots the average net reward for 100 equal-sized FICO buckets between 480 and 830. The dashed vertical lines mark FICO scores of 660, 720, and 780, the cut-off scores for near-prime, prime, and super-prime cardholders, respectively. The graph is based on our baseline sample of 238 million credit cards in March 2019. © Agarwal et al. 2022.

On average, only sophisticated consumers (those at the right-end of the chart) earn positive net rewards as they cash in high rewards and pay low interest charges, being able to pay off their balances in full. By contrast, naive cardholders (those at the left-end of the chart) lose money with reward cards, both in absolute dollar terms (up to 40$ per month) and relative to traditional cards, as they earn less rewards and pay more interest by carrying large outstanding balances.

Of course, one could argue that this is not too different from the reverse Robin Hood story, as generally consumers with better credit scores are also richer. But the association between sophistication and income is weaker than what people generally think. Looking separately at low-, middle-, and high-income individuals shows a pattern of net rewards that is strikingly similar to the one in the chart.

This suggests that sophistication, more than income, drives the redistribution across cardholders.

Comparing the behaviour of naive and sophisticated consumers after they receive a credit limit increase from their bank helps with understanding the mechanism driving the redistribution. Sophisticated individuals increase credit card spending and repayments proportionally. This is not the case for naive consumers. For them, credit card repayments do not increase at all, suggesting that all the additional spending is beyond their capacity to repay. Thus, naive consumers end up with more credit card debt and large interest charges, which likely outweigh the benefits from the rewards.

Clearly, banks are the main winners here. Banks profit from reward cards regardless of the customers’ degree of sophistication. What changes is the source of profits. With naive users, banks earn money primarily via interest charges. For sophisticated cardholders, which are often transactional, banks’ profits come from the high purchase volumes, which generate high swipe fees — every time you pay with a credit card, the merchant must pay a small percentage of the value of the purchase to the bank.

So far the discussion has focused on individual winners and losers, but these programs have also large aggregate effects and increase inequalities. The annualised redistribution from naive to sophisticated individuals amount to more than $15bn. This money flows from less to more educated, from poorer to more affluent, and from high- to low-minority areas, widening existing spatial disparities across the U.S.

The size of this spatial redistribution warrants some action. Policies aimed at boosting competition, like those currently discussed in the US Congress or the cap on interchange fees imposed in the EU, could weaken the incentives for banks to offer massive sign-up bonuses and high rewards on the cards. But such policies must confront the opposition from the industry and sophisticated cardholders.

As a first step, measures aimed at improving financial education and awareness of the costs of incurring credit card debt can help individuals make better financial choices.

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