Credit card rewards increase spending and debt
Federal Reserve Bank of Chicago study looks into effects of bank reward offers
Credit cards that give cash back lead to consumers to spending more and building up greater levels of debt, according to a survey from the Federal Reserve Bank of Chicago.
The survey into the effects of rewards on cardholder behaviour found that when a credit card issuer offers a 1% cashback reward, it ends up having to pay out around US$25 per month to its cardholders. However, it also increases spending on cards by an average of US$68 per month, and increases debt levels by an US$115 each month.
The research found that people tend to switch their purchases from other credit cards when rewards are offered and cardholders’ absolute spending is likely to go up, creating more profit opportunities for banks.
In the wake of the economic crisis card rewards have become increasingly common from airlines, hotel operators, and credit card issuers looking to increase use of their products and boost income levels.
In the case of credit cards, the survey found rewards are an effective way to attract cardholders or convince existing ones to use a specific card for their purchases and borrowing needs.
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.
The survey found that consumers generally spend more and increase their debt when offered 1% cash-back rewards. The impact of a relatively small reward generates large spending and debt accumulation. The greater increase in debt (US$115) compared to spending (US$68) suggests that average monthly payment drops more than the marginal increase in spending from the cash-back program.
The bank researchers said that the reduction of payments within the first quarter of US$38 of the start of the program, suggests that the marginal increase in spending due to the cash-back reward is converted into debt along with a portion of baseline spending.
Furthermore, evidence from credit bureau data confirms that consumers substitute their spending from other cards to the card with cash-back and decrease debt on their other cards. The research found that, even in the long run, there is a persistent increase in spending and debt. Specifically, the average spending and debt rise during the nine months subsequent to the cash back reward is US$76 and US$197 per month, respectively. The reduction in payments is US$83 during the same nine months period.
Certain types of cardholders are more responsive to cash-back rewards programmes. Cardholders that do not carry debt have a larger response to cash-back offers. 11 percent of inactive cardholders during the three months prior to the cash-back program used their cards to make purchases of at least US$50 in the first month of the program. Specifically, inactive cardholders increase their average per month spending by US$220 during the first quarter and their average per month spending only decreases to US$180 during the first nine months. Their average per month increase in debt during the first quarter is US$167. These cardholders substitute spending and debt accumulation from other cards to the cash-back card.
Demographics also affects how cardholders react to cash-back rewards. Average per month spending increases by US$55 by single cardholders and by US$95 by married cardholders during the first quarter. Similarly, single cardholders increase their average per month debt by US$65 as compared to US$111 by married cardholders during the first quarter. There were no significant differences between male and female cardholders. Cardholders that earn less than US$40,000 increase their average per month spending by US$47, compared to US$74 for cardholders that earn more than $40,000 during the first quarter of the program.
Those earning below US$40,000 accumulate US$56 additional debt on average per month versus US$87 for cardholders earning more than US$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. Cardholders utilizing less than 50% utilization of their credit limits tend to spend more and accumulate more debt per month.
The full pdf of the report can be downloaded at: http://www.chicagofed.org/webpages/publications/working_papers/2010/wp_19.cfm