How can credit cards give cash back?

capital-one-cash-backEver wonder how it is that your bank can afford to give you cash back on your purchases, even if you pay off your full balance each and every month? Sounds like a losing proposition, doesn’t it? Like maybe the credit card companies are a little stupid in the head?

Well, rest assured that your credit card company would never give you cash back if they didn’t have the money to cover it, and they would never lose money on the deal. The fact is, they profit handsomely every time you use your cash back credit card.

Here’s how: Every time you use your credit card, the merchant you buy from has to pay an “interchange” fee to the credit card companies. There are actually multiple parties involved in making a transaction work, and each one takes a cut of that fee. If you have a cash back credit card, the bank that issues your card takes a small piece of that transaction fee and refunds it back to you. So, essentially, “cash back” means you are getting a delayed discount, or a partial refund.

Here’s an example to help illustrate: You buy a $100 coat from your favorite store. You pay with your credit card, and $100 goes on your credit card balance. The store then turns to the credit card company to get its money. However, instead of giving the store the full $100, the bank may only give $97 or $98, because the store has agreed to pay the bank a fee on every transaction in order to be able to accept credit cards. So, in this example, the fee paid to the bank is 2% or 3% of the price of the purchase. Your bank then essentially splits that fee with you — if your cash back card offers a 1% rebate, you get your 1% and the bank keeps the rest. You are happy because you got a small discount on the coat (it only cost $99 instead of $100!) and the bank is happy because it got a dollar or more out of the deal. Banks make lots of money through these small fees because there are millions of credit card transactions happening every day.

To recap, you pay $100 with your credit card, the store gets $98, the bank gets $1 and you get $1. These numbers will fluctuate based on the type of transaction, the cash-back formula of your card, etc., but that’s basically how it works.

You may wonder why retailers would pay these fees to take credit cards in the first place. Well, the answer is this: people spend more money when they use credit cards than they would if they had to pay with a cash or check. Various studies have confirmed this is true, but you can probably guess that it would be true even without those studies. It’s much easier to make a purchase with a credit card, and you can buy bigger things that might be a pain to buy if you had to pay by cash or check. Plus, you get a month to float the purchase until you have to pay (or you can take even longer to pay if you’re dumb enough to pay credit card interest). Anyway, your favorite store pays the fee because it believes you will buy more if you use your credit card.

There have been many lawsuits concerning these interchange fees over the past decade; many retailers think the fees have been increased unfairly over time. To NOT take credit cards puts a retailer at a disadvantage in many cases, and the retailers feel the credit card companies take advantage of the situation by increasing the fees. Retailers also say this forces them to raise their prices, so it’s possible you are paying more for your purchases specifically because of your credit cards. However, it’s difficult to prove the truth of all this, which is why there are so many lawsuits 🙂

In summary and in conclusion, this whole article can be boiled down to this answer: you get cash back on your credit card purchases out of the fees the retailers pay the banks.

In the spirit of this article, you might want to check out our list of cash back credit cards.