How Rewards Cards Make Money

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My husband and I only have a single credit card to our name — a card that puts 1% cash back into our son’s 529 account. It’s extremely important to me to be able to send my peanut to any ridiculously expensive private liberal arts college his little heart desires (as my parents did for me), so I love the idea that my grocery and gas purchases are working to make Harvard or Yale a (financial) possibility.

But any time I’ve rationalized a purchase by saying “well, at least that will add another $3 to the 529 plan,” I’ve found myself wondering if I’m really making smart financial decisions by having this card.

That’s a valid concern. While it may seem as though responsible credit card users would make rewards credit card programs a losing game for issuers, the truth is much more pernicious, even for those individuals on top of their credit spending. Here is what you need to know about the psychology behind rewards cards, and what you can do to make sure you’re actually getting the benefit of the rewards. (See also: 5 Myths About Credit Card Rewards)

Rewards Cards Increase Spending 

There is a great reason why credit issuers offer rewards — they work to make even the thriftiest cardholder spend money almost wantonly. A recent study by the Federal Reserve Bank of Chicago, which analyzed data from 12,000 actual credit card accounts, showed that “only a relatively small financial incentive was required to change consumer behavior.”

This study found that the average cash back reward for a 1% rewards program was $25 per month. Considering that an additional $25 each month is a cool $300 per year that you don’t have to work for, that doesn’t seem like too bad a deal. Unfortunately, that wasn’t the end of the story. First of all, in order to earn $25 each month with a 1% cash back card, you must be charging at least $2,500 each month. That’s a hefty monthly credit card bill.

In addition to that inescapable fact, the study found that cardholders increase their spending when they enroll in rewards programs — by $79 each month, just during the first quarter of enrollment. Both that additional spending and the hefty amount cardholders are charging each month would be just fine if cardholders were also paying off their bill every cycle. But the study also found that cardholders increase their monthly debt by $191 each month just during the first quarter of enrollment.

The bad news doesn’t stop there. Apparently, the prospect of cash back can scramble anyone’s brains — even individuals who otherwise are not likely to use credit. The study reports that cardholders who did not use their credit card before switching to a cash back program increased their spending and their debt once they had the carrot of cash back dangling before them. In fact, these responsible credit users increased their spending and debt with a cash back program more than cardholders who previously carried credit card debt did. Basically, cash back rewards programs were likely to entice non-credit card users into debt.

So for the relatively small price of 1% cash back, credit card issuers are raking in profit on all the extra debt cardholders are carrying — both from people who’ve always had an issue with debt, and from those smart spenders who have never carried a balance.

What’s going on here is that credit card issuers are appealing to our vanity by offering rewards. We all believe that we are capable of gaming the system. These rewards make us think that we can easily make some money off of those suckers at the banks. The truth is that most of us aren’t going to be successful — even though we have complete confidence in ourselves.

Gaming the System

There are certainly ways for cardholders to take advantage of rewards programs, signing bonuses, 0% transfers, and the like. Multiple personal finance bloggers have written (and continue to write) about their experiences with playing these games, and how they can earn fairly serious money doing so.

What’s interesting about these “gamers” is that credit card issuers are not worried about them. Even though the ways that these individuals take advantage of rewards cards and bonuses are all perfectly legal and spelled out for each and every cardholder (provided they read their contracts), the number of individuals who do so remains a tiny percentage of all cardholders.

This is because playing these games requires precise budgeting, attention, and most of all, time. Unless you are the sort of person who thinks that balancing your checkbook is fun and gets flushed at the mention of the words “0% APR,” then it is unlikely that you will be able to win the credit card rewards game. For most of us, dealing with our finances is at the very least an obligation and is often an out-and-out chore. For the gamers out there who are able to earn money from credit card rewards programs without giving up a penny in interest, dealing with finances is the most fun part of their day.

The difference between the extrinsic motivation (“I have to deal with my money or else something bad will happen. Sigh.”) and the intrinsic motivation (“Yay! I get to use their system to earn money for free!”) is the difference between believing you can game the system and actually being able to do it.

Earn Rewards Without Paying Interest

Even if you do not become a master-gamer of credit card rewards, it is still possible to earn rewards and keep yourself out of debt. It’s just a matter of recognizing the psychological tricks the card issuers are using. Here are two methods you can use to prove that you’re smarter than the banks think you are.

1. Keep an Eye on Your Account

Paying off your balance each month may sound simple, but the psychology of rewards cards is such that you’re encouraged to spend, and then the bill comes as a shock at the end of the month. If you keep careful track of your spending or log into your credit card account several times a week, you can stay on top of your spending to make sure that you don’t go overboard.

Credit card companies earn incredible profits through cardholders losing track of how much they’ve spent. Rewards cards can further blind cardholders to their own spending habits. It’s easy to become so focused on the money you’re earning that you forget what you have had to spend to get there.

Making sure that you use your credit card mindfully and always know what you’ve charged and how you intend to pay it off will keep card issuers from profiting on your lack of paying attention.

2. Ignore the Category Spending Incentives

On the other hand, not paying attention to some aspects of your card can really help you. Knowing exactly how much you earn in rewards can be a terrible curse, as it becomes a factor in your spending decisions. Don’t let that happen.

For example, in my case, my credit card can earn me a whopping 5% cash back on purchases at certain restaurants, as well as some percentage above the normal 1% at some grocery stores.

I’m a little hazy on the details because I don’t care to know exactly what categories can earn me more cash back. Just like Admiral Akbar, I know it’s a trap. If I start thinking about how much cash back I can earn at a dinner at Applebee’s, it makes me start thinking that dropping $60 on a weeknight meal there is a reasonable thing to do. Instead, I plan out our dinners on the town, and we pay cash for them.

Similarly, I do my grocery shopping at stores that are convenient to me and that have the lowest prices — and I buy my groceries with cash. I don’t want to know how much I could be earning for my son’s education by paying with credit, because that could tempt me into spending more than I budget for. So, I’m satisfied to only earn 1% when I use my credit card — and I only use it on purchases I’ve already planned.

I’ve decided that it is much better for my family to treat the cash back as an unanticipated bonus rather than something to plan for. That way it stays out of our heads when we’re making spending decisions. And we still get a nice little chunk put away each year into my son’s 529.

The Bottom Line

We all feel like we’re such smarties that we can outwit credit card rewards programs. But for the vast majority of us, sucker is a better descriptor. Unless you can make gaming a rewards card a part-time job, you’re unlikely to win big in rewards programs.

It is possible, however, to win “modestly” if you pay off your balance each month and you studiously “forget” about your rewards program until it’s in your (and only your) best interest to remember.