Why Do Banks Reward Their Customers To Use Their Credit Cards?

Today, rewards are routinely given by airlines, hotel operators, and credit card issuers to increase use of their products. In the case of credit cards, rewards are an effective way to attract cardholders or convince existing ones to use a specific card for their purchases and borrowing needs. In 2005, six billion reward card offers were mailed by the credit card industry. Typically, these mailing are randomized and the response rates are very low. For instance, in 2005 the response rate was 0.3% (also see Agarwal, Chomsisengphet, and Liu, 2010). Card companies have pursued aggressive tactics, such as offering cash back, airlines miles, rebates and lower interest rates. The main objective of the card companies is to increase card spending that may result in cardholder’s debt in the future.

In this paper, we study the impact of credit card rewards on spending and debt. We explore three questions. First, do consumers spend more when given rewards? Second, do consumers increase their debt because they receive rewards? Third, do consumers partially or fully offset their increases in spending and debt accumulation by reducing spending and debt on their other credit cards?

We find that consumers generally spend more and increase their debt when offered one percent cash-back rewards. The impact of a relatively small reward generates large spending and debt accumulation. On average, each cardholder receives $25 in cash-back rewards during our sample period. We find that average spending increases by $79 per month and average debt increases by over $191 per month in the first quarter after the cashback reward program starts. Even in the long run, we find persistent increase in spending and debt. Specifically, the average spending and debt rise over the nine months subsequent to the cash back reward is $67 and $204 per month respectively.

We identify certain types of cardholders that are more responsive to the cash back rewards program. Cardholders that do not carry debt have a larger response to the cash-back program. We find that 11 percent of cardholders that did not use their cards during the three months prior to the cash-back program use their cards to make purchases of at least $50 in the first month of the program. Specifically, cardholders that do not use their cards three months prior to the program increase their average per month spending by $238 during the first quarter and their average per month spending only decreases to $197 during the first nine months. Their average per month increase in debt during the first quarter is $242. We find that these cardholders substitute spending and debt accumulation from other cards to the cash-back card.

Cardholders react differently to cash-back rewards based on some demographic characteristics. Average per month spending increases by $67 by single cardholders and by $103 by married cardholders during the first quarter. Similarly, single cardholders increase their average per month debt by $165 as compared to $242 by married cardholders during the first quarter. We do not find significant differences between male and female cardholders. There is little difference between those cardholders that earn less than $40,000 and those that earn more than $40,000 in terms of average monthly spending during the first quarter of the program but those earning below $40,000 accumulate $170 additional debt on average per month versus $227 for cardholders earning more than $40,000 during the first quarter.

Credit constraints also impact the response to the cash-back program. Not surprisingly, those cardholders with higher credit limits tend to spend more and accumulate more debt per month on average in response to the cash-back program. However, cardholders utilizing greater than 50% utilization of their credit limits tend to spend more and accumulate more debt per month.

We are also able to study another tool to increase card usage and debt, albeit more costly, to convince cardholders to increase their debt: APR reductions. During our sample period, the financial institution offered certain cardholders a 10 percent APR reduction. Consistent with Gross and Souleles (2002), we find that consumers react to such a large reduction in APRs by increasing card spending and debt. However, we find that only part of this increase in spending contributes to an increase in the consumer’s balance for all her credit cards, which suggests that consumers shift spending and debt from other cards.

Our paper incorporates key features from several strands of the literature in economics and finance – consumer payment choice, consumption response to income shocks, and behavioral finance. We tie our work to each of these fields and highlight our contribution. First, the literature on payment substitution argues that monetary incentives are effective in enticing consumers to use a given payment instrument over another. While the literature focuses on different types of payment instruments, our analysis suggests that these incentives are also effective in differentiating providers of the same type of payment instrument. Second, we incorporate findings from the consumption literature that study monetary payouts such as tax rebates and their impact on increased spending and debt. Our results confirm one of the main findings in this literature that only a small financial incentive is required to change consumer behavior. Third, the literature on time-inconsistency suggests that at least some consumers increase their spending and debt when offered financial rewards but may incur greater debt than expected. Given our ability to study a cardholder’s overall portfolio, we are able to distinguish between increase in spending and debt on a specific card and how that affects a consumer’s overall balance sheet.

In addition, our results also have policy implications. For instance, the recent regulatory and legislative actions have focused attention on the impact of rewards on consumer choice of payment instrument and who pays for these rewards. Some observers have argued that the recently passed Card Act and recent changes to overdraft access for debit cards in the United States would reduce the ability of issuers to extend rewards. While mandated reduction in cardholder fees and finance charges may potentially affect the level of rewards, we find that rewards have significant impact on credit card debt especially via substitution from another issuer’s credit card suggesting that rewards are an effective tool to steal customers from financial institution’s competitors.

The rest of the paper is organized as follows. Section 2, reviews the literature. Sections 3 and 4 outline the data and provide results, respectively. Finally, section 5 concludes.