Informative article from NerdWallet answers a question that many students may have, which is “How can credit card companies afford to provide such great reward programs like 1.5% cash back?”

Five questions for students:

1. What parties are involved in any credit card transaction?
2. What is an interchange fee?
3. How does the fee in the U.S. compare to other countries?
4. What is the relationship between interchange fees and rewards programs?
5. What do you think would happen if U.S. followed the rest of the world and reduced interchange fees?

First the article explains the three parties involved in any credit card transaction:

Here’s how it works: When you use your credit card at a store or online, the transaction isn’t just between you and the merchant. It also involves three other parties:

•  The bank that issued your credit card (called the issuer).

•  The merchant’s bank (called the acquirer).

•  The payment network that handles the transaction, such as Visa or MasterCard.

As for what the interchange fee is…

But the merchant doesn’t get all the money. About 2% to 3% of the total is kept as a fee, called a merchant discount rate, by the issuer and the acquirer. The biggest part, called interchange, goes to the issuer. The payment network gets a cut of this, though indirectly, based on separate contracts with issuers.

What’s interesting about this fee is that it is so much higher in the U.S.:

In China, for comparison, the interchange fees on general merchandise and travel purchases dropped a few years ago to around 0.8%. In Australia, the fees on most consumer cards range from about 0.25% to 1.38%, and in the United Kingdom, they’re 0.3% following recent legislation.

As for where these fees go, well, as the title of this post suggests, some of it makes it way back to consumers in the form of rewards:

While the U.S. has high interchange rates, credit card issuers here also tend to offer higher levels of credit card rewards compared with other countries, according to an analysis from PYMNTS. Often, these rewards come in the form of enormous sign-up bonuses –– sometimes $500 or more –– and rewards rates as high as 5% for certain items. Such rewards are less common abroad. Meanwhile, outside the U.S., where interchange rates are lower, credit card annual fees are the norm, the analysis points out; in the U.S., they’re easily avoided.

It will be interesting to watch this debate between issuers (who like 2-3% fees) and merchants (who hate these fees) play out in the years ahead.

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Check out the NGPF Activity: Should College Students Have Credit Cards?

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.