The Economics of Credit Cards

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Credit cards are among the easiest way to earn points. Over the past few years, these product benefits have ebbed and flowed, sometimes without an apparent reason. While we will never be privy to the inner workings of a card issuer, knowing the overall basics is useful when it comes to understanding loyalty and rewards. Here is a bit about how it all works.

Credit Card Economics

Let’s say John buys a pair of shoes using his Scotiabank Passport Visa Infinite Card. When a consumer makes a transaction, the cardholder’s financial institution, Scotiabank, receives the interchange fee from the merchant. This occurs via their payment processor and is less the fee that the bank pays to Visa for using their network.

Interchange Process (source: Visa Canada)

Interchange Process (source: Visa Canada)

The interchange fee is a huge part of what makes credit card points possible. The bank uses a portion of this fee to pay for rewards when cardholders use their points. With merchandise and gift cards, the cost for the bank is purchasing those items. With airline miles or hotel points, the credit card issuer buys millions or billions of points in bulk at a fixed cost.

The loyalty program selling the points to the bank makes a margin on the revenue of the points sold subtracted by the cost of fulfilling those rewards (which is another long story).

Banks with Big Credit Card Rewards

View from the Wing wrote about Why Banks Will Keep Paying Big Credit Card Rewards. American credit cards, by far, have the strongest reward offerings worldwide, and rewards costs for banks are rapidly spiraling upwards.

His article makes two main points –

  1. US Banks will continue offering strong signup bonuses because of the collective action problem. All banks need to stop offering large welcome bonuses for the equilibrium to change. This has not happened, and the most prominent attempt by Barclay failed badly.
  2. Rich rewards are necessary to incentivize ongoing spend, and to keep credit cards top of wallet. Instead, issuers are tweaking other benefits, such as price protection and lounge access.

Australia is a good example that validates the latter statement. Australia caps interchange rates at 0.8%. Loyalty programs in Australia generally have less value than their North American counterparts. However, we regularly see welcome bonuses of 100,000 Qantas points or equivalent on premium cards. The downside is increased costs elsewhere – increased annual fees, more restrictive bonus targeting, and merchants adding surcharges on credit card transactions.

source: Chase

source: Chase

Also, keep in mind that there are some products in the US which are currently unprofitable. Much has been publicly written about the Chase Sapphire Reserve. When launched, it was one of the best (if not the best) credit card out there. Richly rewarding with a tremendous signup bonus, and so many people than predicted signed up leading to Chase running out of metal cards for a while. Chase has stated that card has sapped more than $300 million in profit, and analysts predicted the product would not be profitable until the five-year mark.

One difference in Canada is that issuers, especially the big five banks, are unlikely to be losing money on their premium card products. There are multiple reasons, one of which is the affinity of consumers sticking with card issuers they bank with. The marketing proposition contributes to this, with most premium bank accounts waiving the annual fee of the respective credit card (offered by TD, BMO, and RBC).

There is also less competition in the market with fewer cards left to compete for a consumer’s wallet. Issuers are not as compelled to offer better rewards because nobody else is doing that.  Income requirements and minimum credit limits (e.g. for Visa Infinite cards) may filter out some applicants with lower credit scores who are likely to default. This limits them to less premium credit cards with lower reward costs.

Working out Canadian Numbers

However, the primary differential, in my opinion, are lower interchange fees. It’s simple: if the interchange rate is 1.5%, you simply cannot offer a 2.0% rebate on transactions indefinitely. You will lose a lot of money. I went through the interchange charts and found the interchange rates for Visa and Mastercard in both countries.

Premium Visa Signature credit cards in America have an interchange rate of 2.10-2.40%, depending on the merchant category. World Elite Mastercards have a 2.20-2.50% interchange rate, depending on whether the card is or is not present (e.g. electronic and keyed payments). On the other hand, personal Visa Infinite Cards and World Elite Mastercards in Canada have an interchange rate of 1.61-1.71% and 1.86%, respectively.

Visa Canada Interchange Rates

Canadians also hold less credit card debt per person on average, and lenders are more conservative. There are no offers with 0% APR for 15 months on cards here. It also doesn’t help that interchange rates are further on a negative trend. In 2015, Visa and Mastercard agreed to lower the average interchange rate to 1.5%, which will be in effect by 2020.

Interestingly enough, I think the credit card marketplace in Canada has only strengthened. You now have a product like the American Express Cobalt Card, which earns 5x points on Dining and Groceries. A credit card with no foreign transaction fees and no annual fee, which is the Hometrust Preferred Visa, continues, despite the downward pressure on interchange. Reward bonuses of 25,000 points (or a $300+ equivalent) are now the norm. All of these items would have been unheard of four years ago.

However, it doesn’t mean that this would continue. It could simply be a blip where there is outsized value to attract new customers. As View from the Wing writes: “any opportunity that offers orders of magnitude better opportunities than the rest of the industry won’t last over time.” Being savvy and looking for the best deal is simply the best you can do, short of getting influential enough to change the industry.

If you haven’t already read View from the Wing’s post – check it out: Why Banks Will Keep Paying Big Credit Card Rewards

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Comments

  1. Although generally interchange fees are lower in Canada. The Visa infite privilege cards and we mc are approximately the same in Canada. The mc rate for non swiped is 2.49, and visa infite privilege 2.45. Until January 2019, mc we rates were 2.06-2.79 and the rewards offered were not equivalent to the US.

    • Very few people have Visa Infinite Privilege cards. I’m not sure about MC rates, but on average, it’s likely that Canadian interchange rates are inching closer to 1.5% while that’s not happening in the US.

  2. A great read – thanks. It will be interesting to see how the Canadian credit card scene changes over time if churning becomes more prevalent here (as I believe it has). Credit card issuers can’t continue to lose money. We have seem more and more restrictions in the USA because of this.

  3. I’d love to see your perspective on how much some stores ACTUALLY pay in interchange fees, as well as a conversation about the differences between Amex and MC/Visa. Many large retailers aren’t paying close to the average, they’re paying considerably less as they make deals.

    It’s often the interchange company ( the middle man ) that reaps in profits. I think technology is at a place where we can cut out middle men and make the chain more efficient. The less that is ‘lost’ between bank and retailer, the more chances for disruption and rewards ( at least in the short term ).

    • I wouldn’t be privy to that information, but someone like Square or Stripe charges 2.9% on all cards. They make a good margin although some of that is offset by not having any monthly or other fees with a traditional cost+ provider.

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