The merchant pays most of your rewards, through fees built into every transaction
When you earn cash back or points on a credit card purchase, the money comes from the merchant — the store, restaurant, or website where you bought something. Every time a card is swiped, the merchant pays a fee to the card network (Visa, Mastercard, American Express) and the card issuer (your bank). That fee is typically 1.5% to 3% of the transaction amount. The card issuer uses part of that fee to fund your rewards program.
The merchant does not pay this fee willingly. It is a cost of accepting card payments, and merchants build it into their prices. This means all customers — whether they use a rewards card or pay cash — effectively subsidize the rewards that cardholders earn. A customer paying with cash at the same store is helping to fund your points.
The card issuer keeps the rest of the fee after funding rewards. This is how banks make money on credit cards, alongside interest charges from customers who carry a balance.
Key Takeaways
- Merchants pay interchange fees (typically 1.5% to 3% per transaction) to card networks and banks, and a portion of that fee funds your rewards.
- These merchant fees are built into retail prices, so all shoppers — including those paying cash — indirectly subsidize rewards cardholders.
- The card issuer keeps the remainder of the fee after paying for rewards, which is their primary profit source on credit cards.
- Higher rewards rates mean higher merchant fees, which is why premium cards often have annual fees — the issuer needs more revenue to cover the cost.
- Some merchants, particularly small businesses, absorb these fees as a cost of doing business rather than raising prices.
How interchange fees connect to your rewards rate
A card offering 2% cash back costs the issuer more to operate than a card offering 1% cash back. The issuer recovers this cost by negotiating a higher interchange fee with the card network, or by charging an annual fee, or both. A premium card with 3% or 5% cash back on certain categories almost always has an annual fee — sometimes $95 or more — because the issuer cannot cover that cost from interchange alone.
Visa and Mastercard set the interchange rates that banks can charge. American Express operates differently: it is both the card network and the issuer, so it sets its own rates and keeps more of the fee. This is one reason American Express cards often have higher annual fees and higher rewards rates than Visa or Mastercard products.
The card network itself takes a small cut of every transaction — usually a fraction of a percent — before the issuer receives the rest. So the flow is: merchant pays fee → network takes its cut → issuer receives remainder → issuer funds rewards and keeps profit.
Why merchants cannot straightforward refuse to accept cards
A merchant cannot opt out of paying interchange fees on individual card types. If they accept Visa, they accept all Visa cards and pay the corresponding fee for each one. Some merchants have tried to pass the cost directly to customers by charging a surcharge for card payments, but this is prohibited in most states and by card network rules in many cases.
A few merchants — typically gas stations and some restaurants — have found legal ways to offer a discount for cash or debit payments instead. But most retailers absorb the cost and price their goods accordingly. This is why a gallon of milk costs the same whether you pay with cash or a rewards card.
Merchants have limited negotiating power. Large chains like Walmart or Target can sometimes negotiate lower rates because they process enormous transaction volumes. Small businesses have almost no leverage and pay the standard rate.
The role of annual fees in high-rewards cards
When a card issuer charges an annual fee, part of that money goes directly to funding rewards. A $95 annual fee on a premium card is often justified by the issuer as necessary to cover the cost of higher cash back or points rates. Without the annual fee, the issuer could not afford to offer 3% cash back on dining or travel, because interchange fees alone would not cover it.
This is why comparing rewards cards requires looking at both the rewards rate and the annual fee. A card with 2% cash back and no annual fee may deliver more value than a card with 3% cash back and a $95 annual fee, depending on how much you spend. The annual fee is the issuer's way of asking you to help pay for your own rewards.
Some issuers waive the annual fee in the first year to attract new customers, then charge it in year two. Others waive it if you meet a spending threshold. These are negotiation tactics, not signs that the fee is optional — it will eventually be charged unless you close the card.
How interest charges fund rewards for people who carry a balance
If you carry a balance on your credit card, you pay interest — often 18% to 25% annually. A portion of that interest revenue funds the rewards program, even though you are the one paying it. This creates an odd situation: a cardholder who pays interest is partially funding rewards for a cardholder who pays in full every month.
Card issuers rely on this. They expect a percentage of cardholders to carry a balance and pay interest, and they use that revenue to subsidize rewards for the larger group who pay in full. If you pay your balance in full every month, you are benefiting from the interest paid by others.
This is one reason why credit card companies actively market to people with lower credit scores or higher debt levels — they are statistically more likely to carry a balance and generate interest revenue.
Why premium cards have higher annual fees than their rewards justify
A $550 annual fee on a premium travel card seems high until you realize the issuer is funding not just rewards but also travel credits, lounge access, concierge services, and insurance benefits. These perks cost the issuer real money to provide. The annual fee covers some of this cost; interchange fees cover the rest.
The issuer is betting that the combination of rewards, perks, and annual fee will attract high-spending customers who generate enough transaction volume to make the relationship profitable. A customer who spends $300,000 per year on a card and pays a $550 annual fee generates far more interchange revenue than the cost of their rewards and perks.
This is why premium cards are marketed to people with high incomes and high spending patterns. The issuer has calculated that this customer segment will generate enough revenue to justify the cost of the card.
What happens when rewards rates get too high
Card issuers occasionally reduce rewards rates or add annual fees to existing cards. This usually happens when the issuer realizes the rewards rate is unsustainable — either because interchange fees have fallen, or because too many customers are earning rewards without generating enough transaction volume to offset the cost.
When this happens, the issuer is essentially saying: "We cannot afford to pay for your rewards at this rate using only interchange fees and interest revenue." The solution is to lower rewards, add an annual fee, or both. Customers who opened the card for a specific rewards rate often feel blindsided, but the issuer's business model has shifted.
This is a risk of rewards cards: the terms can change. The 2% cash back you signed up for might become 1.5% in two years. Reading the terms and conditions — particularly the section on changes to rewards rates — is important for understanding this risk.
Frequently Asked Questions
Do I pay for rewards through higher prices?
Indirectly, yes. Merchants pay interchange fees that fund rewards, and they typically pass this cost to all customers through higher prices. A customer paying cash at the same store is subsidizing your rewards. However, the relationship between interchange fees and retail prices is not one-to-one — merchants also absorb some of the cost as a business expense.
Why do some merchants offer cash discounts?
Merchants can legally offer a discount for cash or debit payments in most states, because they avoid paying interchange fees on those transactions. Gas stations and some restaurants use this strategy to offset the cost of accepting credit cards. The discount is usually small — 5 to 10 cents per gallon or a few dollars on a meal — because the merchant is only recovering the interchange fee they would have paid.
Can a merchant refuse to accept my rewards card?
A merchant cannot refuse to accept a specific rewards card if they accept that card network (Visa, Mastercard, or American Express). Card network rules prohibit this. However, a merchant can refuse to accept credit cards altogether and accept only cash or debit, though this is rare in the United States.
Does the credit card company make money if I never use my card?
No. If you never make a purchase, the card issuer earns nothing — no interchange fees, no interest, no annual fee (unless you have one). This is why issuers sometimes close inactive accounts. The card issuer only makes money when you spend or carry a balance.
What happens to my rewards if the card issuer goes out of business?
Rewards points or cash back you have already earned are typically protected, because they are considered a liability of the card issuer. If the issuer fails, another bank usually acquires the card portfolio and honors existing rewards balances. However, future rewards you would have earned are lost. This is extremely rare in practice, as large card issuers are heavily regulated and unlikely to fail.