Economics of Churning: Who Pays for Those Credit Card Bonuses?

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An interesting post on Reddit caught my eye called “The Economics of Churning: who pays for the rewards?”

(“Churning” is the milesphere’s term for opening cards, getting their bonuses, closing the cards, and repeating.)

While I don’t agree with the post’s conclusions about who pays for rewards, it does present a lot of interesting information for anyone who wants to understand the business of credit cards a little bit better.

Poster Buddy5000 writes:

I do have an undergraduate and graduate degree in business. And, I do work closely with the credit card processing division of a large retail company. I’m very familiar with what these credit card fees look like from the merchant’s perspective, and how the merchant passes that cost onto consumers.

I’ll use my IHG Rewards Mastercard as an example.

How do the fees work?

The flow of the transactions is:

Customer (me) -> Merchant (my grocery store) -> Processor (companies you’ve never heard of) -> Card Association (Mastercard) -> Issuing Bank (Chase)

I buy some bananas at a local grocery store with my IHG Rewards card. In essence, the grocery store is paying two separate fees: a processing fee and an interchange fee.

The processing fee is negotiable; this is how the processor makes their money. Large merchants have bargaining power and put pressure on their processors to lower the fee per transaction. This fee compensates the processor for building out the technical capabilities to “process” the transaction. These fees are usually a small part of the overall fee

The interchange fee is not negotiable. These fees make up the bulk of the overall fee paid by the merchant. MasterCard sets this fee, based on the merchant’s industry and customer’s card type. The fee is usually remitted by the merchant to the processor, and the processor passes the whole thing onto MasterCard. Then, MasterCard passes (most of) this fee to Chase (the issuing bank).

Simple enough, right? The store accepting credit cards has to pay a payment processor, with whom the average consumer never comes in contact, and a card association (also called a payment network), which is a household name like Visa, MasterCard, American Express, or Discover. Part of that fee paid to the payment network is passed on to the issuing bank, household names like Chase, Citi, Barclaycard, Bank of America, American Express, and Discover. (Yes, American Express and Discover are both issuing banks and payment networks, and the others are not.)

So what are the fees paid to the payment networks? Buddy5000 links to MasterCard’s fees (click “download interchange rates,” and I dug up Visa’s fees pretty easily. The fees are usually a percentage plus a fixed fee and vary by the type of business accepting the card, whether the card is swiped or not (think: online store), what type of card you use (rewards cards cost merchants more to swipe), and how much revenue the store generates (more revenue equals lower percentage owed to payment processor in some industries.)

Buddy5000 gives this example:

Going with my local grocery store example example, these are MasterCard’s 2016-2017 interchange fees (by card category) for the “Base Supermarket” industry.

• Core Value: 1.48% + $0.10 per transaction
• Enhanced Value: 1.48% + $0.10 per transaction
• World: 1.58% + $0.10 per transaction
• World High Value: 1.90% + $0.10 per transaction
• World Elite:1.90% + $0.10 per transaction

My IHG Rewards Mastercard would probably fall in the “World,” “World High Value,” or “World Elite” categories. [Scott: It’s a World, not World Elite card, so it must fall in one of the first two he mentioned.] A plain, no rewards Bank Americard would probably fall in the “Core Value” or “Enhanced Value” categories. So, my grocery store keeps more money when someone pays with a Bank Americard than when I pay with my IHG Rewards Card. They keep even more money when someone uses debit. They keep even MORE money when someone uses debit, and actually runs it through as debit (enters a PIN #). And even MORE money when someone pays cash.

In fact, Mastercard’s debit fee for this category is 1.05% + $0.15 per transaction. Certain PIN debit transactions have a fee as low as 0.05% + $0.21 [Scott: By law].

These swipe fees must are substantial in aggregate. I’ve heard plenty of people say that credit card companies make all their money from people carrying balances and paying exorbitant interest. Certainly that must be profitable for banks, but that doesn’t explain why American Express charge cards (on which you cannot carry a balance) are so profitable that American Express entices people to open them by offering 50,000, 100,000, and even larger bonuses occasionally. Instead of interest charges, the explanation is that swipe fees (and the other benefits to Amex of having a new customer) are worth a lot even without the possibility of customers paying interest.

The Reddit post goes on to argue that “Cash, Debit, and low-reward Credit customers” pay for the rewards of people who collect big sign up bonuses. I disagree. I think profitable, long-term customers who open rewards cards offset unprofitable, short-term customers for the banks. But that’s not what caught my eye about the post in the first place–I liked the clear discussion of how swipe fees work and what they are with links to the actual fees–so I won’t get off track in this direction, and instead I’ll thank Buddy5000 for his contribution to my knowledge.

Check out his full post here.