Credit card loyalty rewards are an integral part of the landscape in consumer finance today. The programs engage customers through various means, including cash back, travel points, and other very useful perks. Such programs, while being so popular, obscure their inner mechanics and financial mechanisms that ultimately make them possible. The article explains how credit card loyalty rewards work, who funds them, how banks structure these rewards transparently, and why some categories have higher rewards levels than others.
How Credit Card Loyalty Rewards Work
Credit card loyalty rewards are incentives provided by the credit card issuer to the cardholder for using the cards to make purchases. These rewards come in several forms, as described below:
Cash Back: This means that a certain percentage of the amount spent is credited back to the cardholder through a statement of credit and sometimes directly into a bank account.
Reward Points: Cardholders are awarded points per dollar spent, redeemable on travel, merchandise, gift cards, or any other set reward.
Air Miles: Connected with travel rewards, cardholders get miles that they may redeem for flights, hotel stays, and other travel-related expenses.
Who Pays for Credit Card Loyalty Rewards?
Now, concerning who pays for credit card rewards, the answer is more than one party. It involves:
Merchants: When a customer makes a transaction using a credit card, the merchant will pay a fee to the bank that issued the card; this is known as an interchange fee. Usually, it ranges from 1% to 3% of the total amount of the transaction. Some of this goes to fund the reward system.
Card Issuers: Banks and other financial institutions that issue credit cards often sponsor rewards as part of their marketing and customer retention programs. The cost of the rewards is offset against interest and fees paid by cardholders.
Cardholders: Those who carry a balance on their credit cards and incur interest charges indirectly contribute to the rewards program. Besides that, fees—like annual fees, late fees, and foreign transaction fees—subsidize these programs as well.
How Banks Structure the Reward Percentage
Banks would design their rewards programs in a manner that is attractive to clients while keeping the bottom lines intact. What will follow is the no-nonsense breakdown of how bank’s structure the reward percentage:
Interchange Fees: The interchange fee is a fee paid by the merchant’s bank (acquiring bank) to the cardholder’s bank (issuing bank) for processing a credit or debit card transaction. This fee compensates the issuing bank for the costs and risks associated with maintaining the card account and facilitating the transaction.
Spend Categories: Often, banks give more significant rewards for specific spend categories, like dining, grocery, or travel. They study consumer-spending trends and determine categories where high rewards may drive more usage of the cards.
Tiered Rewards: Tiered rewards are those where the percentage of reward increases with the increase in spending levels. For example, the card may give back 1% cash for travel for a spend of AED 10,000 , 2% for AED 20,000 and so om
Promotional Offers: These include sign-up bonuses and promotional rates which the banks offer to bring more people aboard. This offer, in turn, encourages initial spending and long-term loyalty.
Cost Management: The banks determine the reward rates based on their profitability models. The banks consider the cost of rewards offered, the expected interest and fee revenues and the competitive scenario. Advanced data analytics helps the banks optimize these parameters.
Popular Spending Categories for Credit Card Rewards
The banks may offer certain categories of higher rewards. The most popular categories usually include:
Dining: Most credit cards are generous with rewards for dining. This is because companies know that for many consumers, dining out is one of the most common expenses and a category that will probably drive regular card usage.
Groceries: Since groceries are a staple expense, this category is usually targeted to come with higher rewards to motivate frequent card usage.
Travel: Big spenders on flights, hotels, and other travel-related expenses; this could mean higher individual transaction sizes.
Fuel: Fuels are a regular need for many customers. Increased rewards on fuel purchases increase high usage of the cards.
Entertainment: These are spends on movies, concerts, and events that involve a wide range of consumers.
Why Rewards Rates Vary by Category
Rewards rates vary across different spending categories. These can be due to a few factors. These may include:
Merchant Interchange Fees: Different merchants and categories charge different interchange fees. Categories that charge higher fees can provide higher rewards. Dining and travel categories usually have higher interchange fees than government services and insurance.
Consumer Spend Patterns: The bank analyzes consumer spending patterns to decipher which kind of spend can be easily pushed more with higher rewards. Categories like dining, grocery, and travel have frequent and high-value spending, hence it justifies high returns to attract more transactions.
Profitability and Risk: Categories such as government payments, insurance, and utilities are often less rewarding, seeing that normally they contribute less to the profit margins of banks and are less likely to involve defaults than discretionary spend categories such as dining and travel.
Competitive Strategy: Higher rewards in popular categories are the competitive strategy that banks use to attract and hold on to customers. Attractive rewards in high–spending categories help to differentiate their cards from those of competitors.
Example:
Let us understand how the loyalty rewards are calculated by working out a hypothetical example. Bank ABC offers a credit card under the following terms for reward earnings :
1% cash back on all purchases
2% cash back on grocery purchases
3% cash back on travel purchases
A cardholder, Ahmed, charges his credit card with the following monthly expenses:
-AED 500 on general purchases
-AED 400 on groceries
-AED 300 on travel
Following is how the rewards will be calculated:
- General Purchases: -AED 500 x 1% = AED5 cash back
- Groceries: -AED400 x 2% = AED8 cash back
- Travel:– AED 300 x 3% = AED9 cash back
Total cash back rewards earned by John for the month = 5 + 8 + 9 = AED 22
Revenue to Fund Rewards:
Interchange Fees: Assuming an average interchange fee of 2%, Bank ABC earns AED24 from the AED1,200 spent by John.
Card Issuer Costs: Bank ABC shares AED 22 with John in rewards; net of this, AED 2 comes from interchange fees. This does not include other revenues like interest charges in case John carries his balance forward, the annual fees, or any other fees, all adding to the bank’s profitability.
How Rewards Are Structured:
Example
General Purchases (1%): This is the standard rate, covering all other spending to provide consistency in card usage.
Groceries (2%): Groceries are a common expense that will encourage more frequent use of the card.
Travel (3%): Higher rewards for travel incentivize larger purchases, international spend, increasing overall card spending.
Conclusion
Credit card loyalty rewards are really a win-win for both the cardholders and the issuers. Consumers gain valuable benefit enhancements to their spending power while improving card usage and customer retention for banks. The understanding of the workings, such as who is responsible for paying for such rewards and how they are constructed by banks, will go a long way in setting consumers in better positions in using them to their full potential. More importantly, transparency is vital to ensure that cardholders are fully aware of how to effectively earn and redeem their rewards.
