Credit cards are a critical part of good personal financial management and provide substantial benefits over almost any other form of payment for consumers. They automatically discount your spending and provide protections against fraud and risks that are simply not available through other methods.
But credit card companies have become experts at creating an illusion of value to differentiate what is a commodity service, obfuscating the true return to consumers whilst systematically stripping the average account down to minimise cost and maximise profit. We show you how.
The best credit card is going to be the one that provides the highest discount and the most complete protections — easy, right?
Except it isn’t easy and consumers are losing billions of dollars in unredeemed rewards and benefits and in the opportunity cost of having a card they think is right for them but actually may not be.
An entire industry has evolved to help people decide which card to choose like Credit Karma, Nerdwallet and many more — except these are funded by the very companies that they purport to advise on and claims of an absence of bias must be taken carefully.
There are a lot of similarities between casinos and credit card companies and we can learn a lot from the comparison.
In casinos, the house edge ensures the house always wins over customers and the same is true with credit cards. We all know this intuitively but, in both gambling and credit cards, we all still play in the hope we might beat the odds — we won’t.
The relationship between the house and player is entirely asymmetrical. A complex series of calculations and huge data set ensure management towards the inevitable outcome. The player has only hope alone that they will be the one that beats the odds. But people are terrible at working out probabilities and we are hardwired to be biased towards behaviour that benefits the house. We know the odds of the house winning are greater than the player, but we believe we will be the outlier.
In terms of credit cards, it’s undoubtedly true that you’re better off using a credit card than any other form of payment if you can afford to pay off the balance completely each month. So to an extent, if you diligently pay your balance, you’re already winning over say cash. But credit card companies seek to attract your business by over-inflating the value they provide—though they replace casinos’ jackpot imagery with promises of free trips to white sand beaches. Once they have you, they work very diligently to ensure that you don’t truly cash in.
The primary sources of direct revenue for a credit card company is interchange (a share of the fees that are charged to merchants and passed on to the issuing bank — anything between 1.6–2.3% typically) when you spend and interest (often between 14–24%) and fees when you don’t pay it back on time. Indirect value is created when customers are acquired through a credit card and then cross-sold other services such as Checking and Savings accounts.
There are 3 types of credit card customer from an economic perspective
Inactive is defined as 1 transaction in the last 12 months — a pretty low bar. The reality is with almost 4 cards per person, around 80% are effectively inactive. These customers are a cost to be borne by the active customers
It costs on average $200 to acquire a credit card customer and, with almost 80% of cards inactive, the average active customer has to make up not only their own cost of acquisition, but at least $600 of other inactive cards before they are profitable. In 2016, the credit card industry brought in $163 billion—clearly, each active customer is more than just making up the cost of inactive cards.
When credit cards first became available, only the most affluent could access them—credit card companies were very quick to market their cards as status symbols. This model has endured even as credit cards have become ubiquitous. The journey of the metal card from highly covetous to commonplace is a great example.
Points systems were introduced — a proprietary currency that banks controlled so that they could give the illusion of value “2x points!” without necessarily delivering double the value. They could also trade these points to other companies for their goods and services — most notably airline miles. Actually understanding the true value of these products became increasingly hard and is almost totally dependent upon personal circumstances and the time and place you want to use them — the more unpopular the destination and the season, the more your points are worth.
Credit cards are a hugely successful and profitable business — over $3.8 trillion is spent on them in the US each year, with $1.08 trillion of that as debt. Remember: the APR number is an average of 18%; that’s a lot of money. The top 10 card companies own over 80% of that debt and, in their desperate rush to attract new consumers for what is essentially a highly commoditised product, they will go as far as they are able to in convincing you their product is best. Sometimes, they go too far.
With credit card propositions becoming so complicated, the amount of work involved in understanding them and maximising your return is exponentially higher. The irony of personal finance is that whilst everyone wants more money and it’s fun to spend it, managing money is complex, boring, hard and repetitive—few people have the time and inclination to put the required effort in. Banks know this and act accordingly.
“If you don’t want to work at it, cash back is the easy decision.”
—Jim Miller, senior director of banking services at J.D. Power
To work out the value vs the perception, we looked in detail at 3 popular affluent cards: Chase Sapphire Reserve, Amex Platinum and Citi Prestige. They are similar in many respects with all the trappings of a high-status card:
With a lot of effort (in this case, several weeks of work by an MBA Graduate from a prestigious school), it is possible to work out the relative cash back equivalent of each of these cards.
It’s not easy and it’s not exact — it’s designed that way so the average consumer will never fully grasp the true value of their rewards. It is, however, what we believe to be the best estimation of the real return to consumers these cards offer. Only the issuer know the real number and they are not sharing; a casino never advertises the likelihood of winning, they just show you what it looks like to win.
We expect a lot of push back — many people make a living giving advice online to others about which cards to choose — paid primarily by the issuers. Many consumers have used their cards for many years and feel they have a personal affinity with them. Some people just like the feel of metal cards and don’t care about looking any deeper. But if you’re interested in learning what value your card is delivering, we crunched the numbers:
You can see the calculations and links to the tools and data here
Each of these cards delivers—somewhat surprisingly, given they are positioned as affluent cards with rich value propositions — less than the average market rate return of 1.25%.
There will always be outliers who game the system and secure differentiated value from their credit card issuer. They know this and it’s allowed for in the model. All that matters is overall portfolio performance; all that matters is that the house edge keeps the credit card companies always winning. In many ways its good for issuers to have Rewards Hackers promote their winnings — just like a casino. It keeps the illusion alive. But the majority of people won’t spend the time and effort to ever maximise value—and they are paying for the few who do.
If this seems like an awful lot of work, it is. But it doesn’t have to be. We could change the model entirely and provide a credit card that doesn’t promise to change your life, but does deliver good value for money day in and day out. Where everyone wins equally and fairly—and where it doesn’t require an MBA to achieve true value. That seems like a really innovative idea; that’s what we plan to create.