This is a special guest contribution from Steve Sildon, Senior Managing Editor for CreditCardAssist.com. Steve writes about a variety of personal finance topics, providing financial tips and guidance on a variety of subjects including credit cards and an assortment of other credit-related topics.
Most people are familiar with the concept of reward credit cards – simply using your card earns you something back in return, like a cash rebate or maybe even store discounts. Rewards programs offer ‘points’ that can be redeemed for discounts on merchandise, travel rewards discounts and even cash rebates. In fact, of all the various rewards programs in the market, the cash back rebate is by far the most favored rewards program of any. The concept of getting a cash rebate on purchases is beloved by American consumers who adore the idea of getting "up to 5% cash back" on their purchases just for using their cards. For whatever reason, Americans just love the cash back concept. There’s a problem with this scenario, however. The credit card companies are actually the ones making out like bandits with these rebate programs, not consumers. In fact, credit card incentive programs such as cash back rewards drive far more merchant sales volume and profit for credit card issuers than most people realize.
Andrew Kahr, the CEO and founder of First Deposit Corp., later known as Providian, and a financial services consultant for the credit card industry is widely recognized as the innovator who single handedly reshaped the industry with credit card incentives. In an interview for the PBS Frontline documentary The Secret History of the Credit Card in 2004, Kahr talked about the history of credit card incentives and the innovative concepts that he pioneered, including among others, two percent minimum monthly payments (instead of 5%), universal default, 0% APR teaser rates, as well as cash rebates on purchases.
In fact, Kahr was the first to propose the concept of the 1% cash back rebate program to credit card companies, a concept that was extremely controversial at the time. According to Kahr, banks and card issuers were very concerned about “revolvers”, those who paid their card balances in full every month. Kahr’s cash rebate program shocked the banks, who were having a tough time figuring out how their revolving card balance customers could ever be profitable. The prospect of giving those customers an additional 1% cash rebate seemed ludicrous. Kahr contended that there were plenty of “downstream” revenue opportunities, including the likelihood of eventual interest charges and fees (on those same customers) that would more than make up for the 1% cash rebate. Persisting, Kahr convinced card issuers to test out the program. Cash rebate programs eventually became a huge success and have been enormously profitable for credit card issuers. According to TNS Global's Financial Services, 57.4% of all rewards cards in the marketplace today are cash back credit cards.
Another incentive program that Kahr came up with was the concept of the 0% APR teaser rate. It’s no mystery to anyone that charging people zero percent interest seemed like a difficult way to profit from lending money. Incentivizing customers to transfer their high interest credit card balance to a card that was charging 0% for even a short period of time sounded easy enough, but how could the card issuer possibly make money doing that? Kahr contended that even after the balance had been transferred that the cardholder would continue to use the card to make purchases and get cash advances, earning the card issuers interest and making the account more profitable in a shorter amount of time. The balance transfer effectively served as a “loss leader” for the card issuer to win the account, eventually profiting from it “downstream”.
Kahr encouraged this practice even though luring these customers over with 0% APR offers would require as long as 2 or 3 years to pass before the bank would earn back what they had invested with the offer. Kahr theorized that growing the customer base more aggressively and competing in the cut-throat credit card world would require these highly incentivized offers. After one of Kahr’s clients tried out the zero percent offer, the rest of the industry followed suit and the zero percent teaser rate has now become a staple of credit card marketing lexicon.
Some would argue that Kahr’s innovations have led to some of the credit market difficulties that American consumers are suddenly struggling with so mightily. The concept of universal default, which Kahr also spearheaded, has been so vilified that card issuers have started to pull back from it entirely. Universal default allows card issuers to charge higher APR’s on an account resulting from any “material” change in a cardholder’s credit profile. In fact, the practice has been derided so heavily by consumer groups that Congress recently enacted legislation to prohibit universal default entirely.
The concepts that Kahr was responsible for have been criticized heavily, but no doubt will spur more innovation in the future. The recent melt down in the credit markets will only spur the development of even more financial innovation, requiring the innovators to get very creative in order to appease consumer groups and lawmakers while also providing consumers’ with better, more effective products and services.