Credit card companies are in the business of making money, yet they often advertise incentives that feature rewards such as cash back on credit card purchases. For example, Chase (JPM) offers up to 5% cash back on its Chase Freedom Rewards Card, as does the Discover Card (DFS). How can these companies offer such seemingly generous deals for consumers and still make a profit? (For more, see: Credit Card Tutorial.)

Cash Rewards Programs: The Fine Print

First, it is important to read the fine print. Most cash rewards programs have an annual maximum limit, so that it may offer 5% cash back rewards, up to a maximum of $1,500 per year. Other cards only offer cash back for certain categories of purchases, such as at restaurants or gas stations. The fine print for the Discover card's latest cash back bonus program is revealing. It reads:

*Sign up to earn 5% Cashback Bonus on up to $1,500 in combined restaurant and movie purchases made from 4/1/15 (or the date on which you sign up, whichever is later) through 6/30/15. Restaurant purchases are those made at merchants classified as full-service restaurants, cafes, cafeterias and fast food locations. Movie purchases are those made at merchants classified as movie theaters, video rental stores, and online movie ticket services. Purchases made using Near Field Communication (NFC), virtual wallets or similar technology may not be eligible. Purchases made at warehouse clubs, wholesale distributors and discount stores are not eligible. Rewards are added to your Cashback Bonus account within 2 billing periods.

It is made clear that this cash reward bonus program only applies to purchases made at restaurants or those associated with movies, and is capped at $1,500. Furthermore, the reward period lasts only for the months of April, May, and June of 2015. It also states that if you use a credit card with NFC technology or from a virtual wallet such as Google Wallet (GOOG), it may not count towards the program. (See also: Credit Card Rewards: Cash Back Vs. Airline Miles.)

With a credit card program with a $1,500 cash back limit per year at 5%, any spending over $30,000 would not contribute to accumulating any further cash back rewards. (For more, see: Rewards Credit Cards.)

Because most consumers do not take the time to read the fine print, they may open a credit card account under the impression that cash back rewards programs are much more generous and universal than they actually are. (See also: Investing in Credit Card Companies.)

It's Not 'Free' Cash

When merchants accept payment via credit card, they are required to pay a percentage of the transaction amount as a fee to the credit card company. If the card holder has a participating cash back rewards program, the credit card issuer is simply sharing some of the merchant fees with the consumer. The goal is to incentivize people to use their credit cards when making payments rather than cash, which earns them no rewards. The more that a consumer uses a credit card, the more merchant fees the credit card company can earn. (See also: Comparing Credit Card Companies.)

Additionally, credit card companies make money by charging high interest rates on credit and issuing late fees for balances that carry over from month to month. The more a consumer uses their credit card, the more likely it becomes that they will miss a payment or carry a balance for which they will owe fees and interest. According to the Federal Reserve, the average credit card interest rate is 13.68% APY with almost $900 billion in outstanding revolving credit. Furthermore, according to Statistic Brain, 56% of all consumers carried a credit card balance over the past 12 months, with 26% of those balances increasing rather than getting smaller.

Credit cards that offer the most generous sounding rewards programs also often carry the highest fees and interest rates, compared to a similar card with a lower rewards program, or none at all. 

The Bottom Line

Cash back rewards sound enticing, and they can help certain consumers save a bit on credit card purchases. However, once taking into account the restrictions and qualifications spelled out in the fine print, including limitations on how much cash back credit card users can earn per year, these programs do not look as generous as they may on the surface.

Because these programs are incentives for consumers to use their credit cards in lieu of cash or debit cards, they generate increased merchant fees for the credit card company and may also cause some consumers to increase their debt, providing yet another source of revenue for the credit card company. Rather than draining corporate profits, cash back rewards programs are ingenious marketing tools that actually increase credit card companies' bottom lines. (For more, see: Find the Top Cash Back Credit Cards.) 

 

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.