UAE: Where does the money for credit card rewards come from? If you thought credit card companies, think again!

Dubai: Credit card companies are offering better rewards and signup bonuses, and you as a consumer earn points, miles, and cash back. But how do card companies afford to offer such rewards?

Credit card issuers pay for rewards with revenue primarily from two main sources: the consumer and the merchants who accept their cards.

As a consumer, you pay interest whenever you carry a balance on your card and fees whenever your payment is late or you get a cash advance.

Retailers pay card issuers in the form of ‘interchange’ fees, which are set by credit card processing networks like Visa and MasterCard to cover both the risk and cost of processing credit card payments.

Rewards credit cards have higher interchange rates

There are numerous types of interchange rates that can be applied to a credit card transaction depending on the type of business, the type of card being used, the transaction amount, and how the card is used.

Interchange rates include a percentage of the transaction amount plus a flat fee. Interchange is just one type of fee retailers pay to accept credit cards. They also pay fees to the credit card networks and their merchant processing providers.

Rewards credit cards have higher interchange rates than the credit cards that don’t have rewards because the card issuers have to recoup the cost of paying the rewards.

For instance, if you used a ‘Visa Signature Preferred’ rewards credit card to buy dinner out, the interchange fee would be 2.40 per cent of your bill plus a negligible fee.

So on a Dh100 tab, the restaurant would pay Dh2.50. If you used a non-rewards card, that rate might be 1.54 per cent plus the minimal fee, or only Dh1.64.

How the cost is passed on to consumers

Retailer interchange fees are just one form of credit card company revenue. Rewards are also funded through the interest and fees that issuers receive from cardholders.

Whenever a consumer carries a credit card balance, interest in the form of a finance charge is applied to that balance.

If you truly want to benefit from your rewards credit card, you shouldn’t carry a balance and you shouldn’t pay any avoidable fees, particularly late fees.

If you’re shopping for a new rewards card, look for one without an annual fee, unless you’re sure the rewards you’ll earn will more than offset that cost. Always check the interest rates and fees on the credit card disclosure charts.

Interchange and rewards can go hand-in-hand

However, interchange and rewards do go hand-in-hand in one key way: Interchange fees and rewards are both tied to purchases. Aside from sign-up bonuses, rewards and interchange are both figured as a percentage of a purchase.

You can earn rewards — often 1 per cent to 2 per cent of a purchase — while your issuer is taking in a similar amount in interchange fees. Interchange fees doesn’t always cover 100 per cent of the cost of rewards.

Some cards, for example, offer 5 per cent rewards in certain spending categories, up to a certain spending cap. The issuer would make much less than that on interchange fees.

Experts say that in some ways, rewards could be a ‘loss leader’. A ‘loss leader’ is a product or service that loses money but attracts enough customers to offset that cost.

For example, interchange might not fully cover a cardholder's rewards, but that customer might end up paying enough interest that the issuer makes a profit on the account.

What does this mean for you?

Credit card companies need money to offer rewards, but you can still avoid unnecessary charges while earning them:

Pay your balance in full and on time every billing cycle. When you do so, you won't pay interest. If it's absolutely necessary to carry a balance, go with a no-fee card that offers a 0 per cent intro rate period, instead of pursuing rewards.

Get a no-annual-fee card, unless you’re a big spender. The rewards earned on a card after a year of spending should far exceed the card's annual fee. If they don’t, look for a no-fee card with better rewards.

Get a sign-up bonus with a reasonable spending requirement. A sign-up bonus can be suitable, if you can meet the spending requirement without busting your budget. If that’s not possible, decline the offer.

When an issuer offers a credit card, even one with great rewards, it's ultimately looking out for its own financial interests. Before applying, make sure you're looking out for yours.