Putting a Price on Rewards
Your credit card can pay you cash back or even let you hobnob with the stars. Here's why it's often a bad deal
Paying a stranger to buy you presents might sound like an odd use of money. But if you're one of the 80 million Americans using a credit card with rewards, you're doing just that—and probably paying more than the presents are worth.
Rewards cards offer gifts in exchange for card use, including cash back, airline miles, and access to special events. They are now used in 84 percent of credit card purchases, more than double the 2001 number, according to the research firm Aite Group. While many people enjoy their rewards, what they often don't realize is that they're paying for them, in the form of higher interest payments, annual fees, and what economists dub "purchase acceleration."
"People find their motivation increases as they get closer to goals," says Ran Kivetz, business professor at Columbia University. As people close in on a credit card reward, they're likely to spend money more quickly to reach it, he explains. That could mean buying a Prada purse that you don't necessarily want, or splurging on a steak at Morton's, to build up reward points when it would be easier—and, in some cases, cheaper—to just purchase the reward on your own.
Some credit card companies take advantage of purchase acceleration by alerting consumers, via letters and E-mails, when they are nearing a reward threshold. "It's a way to remind people you're close, you've almost hit it," says Lars Holmquist, president of TSYS Loyalty, which works with financial institutions on their reward programs. According to Holmquist's data, consumers do indeed accelerate their spending as they get closer to rewards.
Consumers also tend to spend more after receiving a reward, Holmquist adds. If the reward is an airline ticket, then the consumer is likely to also rent a car and a hotel room, and pick up a souvenir or two. "You might say, 'I got something for free—I don't mind spending a little bit more to complete the experience,'" Holmquist says.
Rewards cards' often higher interest rates and annual fees also cost consumers. At American Express, for example, a consumer with a green card, one of the company's lower-cost rewards cards, can earn a $100 gift certificate to Bloomingdale's after spending $10,000. The card carries a $95 annual fee, essentially canceling out the value of the reward. American Express says consumers who spend only $10,000 a year on their cards still benefit because the card carries a range of other benefits, such as warranty extensions and travel insurance.
Spend. For the nearly 60 percent of consumers who carry a balance on their credit cards each month and pay interest on it, rewards can be particularly costly, because they can encourage even more debt. "Anything that will make them feel less guilty about using their card is going to increase spending...It would definitely be cheaper for them to get [the rewards] on their own," says Susan Menke, senior financial services analyst at the research firm Mintel.
Even cash-back programs, which typically return between 1 and 5 percent of card spending, can be deceptive. "If you're [paying] a huge amount in interest but getting pennies in savings, people love that stuff, but they're definitely not coming out ahead," Menke says.
Discover's Get More program, for example, provides 5 percent cash back on certain rotating categories throughout the year and up to 1 percent cash back on everything else. If a consumer spent $10,000 a year, including $500 in the special categories, then he would receive up to $120 at the end of the year. If the same consumer carried a debt of $1,000 at 15 percent interest, the annual interest payment would be $150-more than the cash back. Discover says people should select their card based on their situation; the company's Motiva card, for example, is designed for people who carry debt. After six on-time monthly payments, cardholders receive the seventh month's interest back.
Consumers who carry credit card debt would be better off shopping for a card based solely on the interest rate, says Travis Plunkett, legislative director of the Consumer Federation of America. Websites such as www.creditcards.com and www.100best-credit-card-reports.com compare annual percentage rates, which typically range from 0 to 20 percent.
Credit card companies increasingly aim rewards programs at consumers who carry debt over each month, says Gwenn Bézard, research director for the Aite Group. But even high-income individuals are at risk for overpaying for rewards. Cards that target affluent consumers are ramping up luxurious experiences offered through their rewards programs, such as suborbital space flights (American Express) and a private meeting with Elvis Costello (Visa). "The trick is to come up with something that looks great in your eyes, but the cost is actually not as high as your perception of the reward," Bézard says.
There is one group of people with little to lose from rewards programs: those who pay off their balance each month, avoid annual fees, and don't succumb to the temptation of purchase acceleration. For those consumers, says Menke, "it's basically getting something for free."
This story appears in the July 2, 2007 print edition of U.S. News & World Report.