How do credit card reward programs work?

Point-based loyalty programs have become a familiar part of the credit card market over the past decade. But as manipulation and abuse of such programs increase, a growing chorus of industry experts are questioning the real value of such programs.

Loyalty cards

Financial institutions have traditionally been reluctant to propose rewards involving point accumulation, but in recent years the concept has gained broad popularity on both sides of the transaction. Easy credit in the early 2000s contributed to rewards programs proliferation, and although credit limits and eligibility requirements have tightened in recent years, credit card suppliers continued to offer loyalty programs to encourage spending on credit.

Loyalty cards encourage spending by offering points for credit card purchases, which may in turn be used to make further purchases. Originally pushed by credit card providers – who make money from each transaction – the system has been widely adopted by merchants, who also benefit from increasing sales.

A double-edge sword for consumers

Rewards programs create attractive incentives for card holders by offering free flights, hotel stays and other financial advantages. But some loyalty programs have also inspired exploitation and abuse, with a small but significant portion of users racking up “ghost transactions” that earn points without actually adding anything to the economy.

One popular technique is to purchase multiple gift cards with credit and then use the gift balances to pay off the credit card balances which were used to purchase the gift cards! Although technically legal, such schemes consume resources in an exploitative manner, ultimately leading to higher payment processing costs for retailers, who, quite naturally, pass those costs on to consumers.

Some economists argue that rewards programs distort incentives and upset natural credit use patterns.The bottom line is that card holders should read and understand the fine print of loyalty program rules, as gains from cashing in points may be offset by the costs of using additional credit.