Academic journal article Financial Services Review

The Value of Credit Card Benefits

Academic journal article Financial Services Review

The Value of Credit Card Benefits

Article excerpt

Abstract

Banks offer various economic incentives to customers to pay with their credit card rather than cash. Still, many individuals either elect to pay with cash or are unable to acquire credit cards. What benefits do these people lose by paying in cash rather than credit card? This paper demonstrates two opportunity costs associated with cash payments-frequent flier miles and payment float. Under most scenarios, the opportunity cost of cash payments versus benefit accruing credit cards is large. For example, individuals or businesses charging $5,000 each month can realize a present value opportunity cost of more than $19,000 over a five-year horizon. The results help banks optimize their offerings and individuals optimize their payment patterns. © 2010 Academy of Financial Services. All rights reserved.

JEL classification: L83; G2

Keywords: Credit cards; Frequent flier miles

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Credit card use has increased dramatically over the past 40 years. Between 1989 and 2006, credit card use increased by a factor of 29 times (Garcia, Lardner, and Zeldin, 2008). In 2004, about 75% of U.S. families had credit cards and about 58% carried a balance on their card (Bucks, Kennickell, and Moore, 2006). This phenomenon is not limited to the United States as studies confirm a worldwide effect (see Abdul-Muhmin, 2007; Bolt and Humphrey, 2007; Goyal, 2008). Increasing credit and debit card use impacts the global economy. For example Amromin and Chakravorti (2009) find greater debit card use decreases demand for small denomination currency and coins used to make change. One factor influencing credit card use is the incentive benefits derived when using the card (e.g., frequent flier miles or cash back bonuses). Because these benefits have real economic value, individuals should consider the tradeoffs when selecting a payment method.

In 2006, Visa and Mastercard's transaction volume approached 6.5 trillion dollars. These transactions include 4.3 trillion (66.8%) for purchases and 2.2 trillion (33.2%) for cash (e.g., ATMs). The United States and Europe account for about 44% and 31% of total volume, respectively (HSN, 2007). Vertís (2007) estimates 48% of credit card purchases accumulate points to purchase merchandise or airline tickets. More than one-third of consumers choose credit cards based on reward maximization (Lipsman, 2007). Not surprisingly, nonbenefit generating credit card usage declined from 38% to 31% between 2003 and 2007 (Platon, 2007; also see www.creditcards.com).

Frequent flyer program's impact on air travel is well established in the literature. These programs' influence airline choice (Toh and Hu, 1988) and route choice (Morrison, Winston, Bailey, and Kahn, 1989). Chin (2002) finds people typically join about two frequent flier programs; however, they tend to favor one program when making travel plans. While the free trips are strong incentives to customers, frequent flier programs also boost a carrier's business by 20-35% (Stephenson and Fox, 1987).

Despite credit card prevalence in transactions, surprisingly little academic research examines the costs and benefits associated with reward cards. This paper examines the opportunity costs associated with cash versus credit card payment methods. Specifically, frequent flier benefits and the gain associated with the cash float are the two benefits calculated. While other benefits associated with credit card usage exist, including purchase protections and loss protection, this research examines only frequent flier benefits and float. The results suggest significant opportunity costs exist when consumers use cash rather than credit cards.

This research has implications to many stakeholders groups. In particular, consumers, corporate, and regulator perspectives are germane. For consumers, what are the potential benefits derived by purchasing goods and services with reward cards? …

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