The Ultimate Guide to Reward Travel: Chapter Three

The most detailed guide to earning and using frequent flyer miles, hotel and credit card points for reward travel.

What You’ll Learn in Chapter Three

  • What happens when you travel for free?
  • How credit card issuers make profit?
  • What is the Reward-credit cycle

People tell us all the time that “it sounds too good to be true.” How can I travel for free – what’s the catch? Well, there isn’t a catch. Once you understand the reward travel mechanics of how points get to you in the first place, you’ll see that no catch is needed. The ticket is already bought and paid for!

3.1 What happens when you travel for “free”?

Reward travel can be incredible. It sounds too good to be true when you hear that people are literally flying around the world and having amazing vacations that would otherwise cost tens of thousands of dollars, but instead cost just a few hundred dollars and some reward points. Once you understand the conditions that support reward travel, it becomes a lot easier to see how this can happen (and it does, every day)!

When you make a reward booking, it can costs as low as $5.60. That feels like free travel! But, you should understand that your seat on the plane or your hotel room night has actually already been purchased. The points you use to make the booking were ‘bought’ in one way or another.

If you earned miles by flying around the world, embedded in the cost of your ticket was some amount to buy the miles you earned in return. If you earned them through credit-card transactions, a small slice of the profits the credit card company makes goes to paying for those points to be redeemed at a future date. Know this: whenever you use points for a reservation, somewhere down the chain it was already paid for with cash.

The beautiful part is that when it was paid for, nobody knew how you would use those points. You might use them for something worth 1.25 cents per point, or perhaps for something worth a whopping 4.5 cents per point. If you use them poorly, whoever gave you those points makes more of a profit. If you use them well, you come out on top by maximizing your value potential.

Summary Point 1: it’s already been paid for.

It’s also important to remember that rewards are a currency with limitations. The airlines and hotels make all the rules, so it’s not ‘as good as cash.’

First, they decide what’s available. During busy times or for the most luxurious travel, they may decide that only a few seats or rooms will be available. If some other savvy traveler books it with points, you’re out of luck. The travel providers could even decide that no reward bookings will be available. If there’s no availability, your reward points won’t get you anything.

On the other hand, if travel providers know that a seat or hotel room will go unsold, it’s better for them to let you burn off your points on something they had little or no prospect of selling than to let it go completely unused. The marginal cost of adding an additional passenger on a plane that isn’t full is almost nothing. The same applies for a hotel that has empty rooms. When you use your reward points, it reduces the liability hanging over their heads that you might come knocking on their door sometime in the future on a ‘non-revenue’ booking.

Summary Point 2: they control availability and manage it in a way that’s best for them, not you.

It’s also true that even a ‘non-revenue’ reward booking is a potential revenue opportunity. This is sometimes true for airlines (perhaps you’ll purchase something in-flight) but very commonly true for hotels. You’re a captive audience for their additional goods and services. Room service? Profit. Spa treatments? Profit! Get the idea?

3.2 How credit card issuers make profit

Credit card issuers make money in three main ways: interchange fees, cardholder fees, and interest income.

Let’s look at each in a little more detail:

  • Interchange (Transaction) fees: This is an industry term for the fees that the card issuers earn when you actually use your card. It’s usually a 1%-3% fee that ultimately the sellers (store owners, etc.) pay for the convenience of being able to accept credit card payments. Every time you swipe your card to pay for an item, the credit card issuer receives a transaction fee.
  • Cardholder fees: These are the annual fees that you pay to “hold” a certain card, like being a member of a club. Annual fees range in price, but typically offer benefits that outweigh the fees. All fees and benefits are disclosed.
  • Interest income: If you carry a balance on your card from month to month, you are charged interest. This interest is typically very high compared to mortgages, car payments or other types of borrowing. Any sound financial advisor would tell you to pay your balance in full each month to avoid fees.

So where do rewards fit in?

Well, in order to make any of the income described above, credit card issuers need cardholders – people to use their cards! That’s the only way they can earn transaction fees or membership feeds or their juicy interest income. So how do they encourage you to sign-up for their cards so they have a chance to make money? You guessed it – by giving you reward points!

In fact, the credit card industry is currently so competitive, they are willing to offer a ton of incentives (in the form of sign-up bonuses) to get you to pick their card over their competitors for some of your delicious spending (and the transaction fees they earn along with that spending).

The amount of points you can earn from a single card sign-up and incentive bonuses could be 25,000, 50,000, 75,000 or more. On rare occasions even 100,000 points are possible in just a few months! Not to mention the potential to earn interest off of you if you don’t pay your bills on time (which, after reading this you most certainly will)!

The points they offer vary to reach different audiences. Some offers have hotel points, some have airline miles, and others offer their own reward currency. If Chase gives you, for example, Ultimate Rewards points, those are internally generated and accounted for. But for something like the Chase United MileagePlus card, where do the miles come from? More on that coming up next.

3.3 Reward-credit cycle

So, we now know that miles and points are created by airlines and hotel chains (the travel providers). How do those points end up getting attached to credit card offers? It works like this: credit card companies buy miles and points from travel providers. That’s right. All those ‘free’ miles you earn on your travel reward credit card were originally paid for by credit card issuers. Credit card companies buy rewards in bulk from travel providers so that they can attach them to their card products to entice you to become a cardholder and put your spending on those cards so that they can make money from your transactions.

In 2014, United Airlines earned $2.9 billion from selling miles to the likes of Chase and others. Similarly, Southwest Airlines made more than $400 million by selling miles to Chase alone in just the second half of 2015. So if you’re an airline, you LOVE this! Selling miles helps offset the volatility with actual paid flights, which move up and down with seasonal trends, the price of oil and fuel, and economic downturns.

The credit card companies found another source of revenue; consistent customers with big pockets who buy miles year in and year out. The impact of these purchases is so important to the airlines that in 2009, Citigroup basically saved American Airlines from going under by pre-purchasing $1 billion worth of American Airlines AAdvantage miles! Hotels do the same thing. Starwood hotels, for example, has a partnership with American Express.

What’s in it for them?

Ultimately, the travel providers have already been paid even before the miles reach your account. It’s up to you to cash them in for the travel they are worth. To put is simply, the rewards go from the travel providers to the credit card companies. Then, the points get packaged with various credit card offers. Finally, they go out to you for spending money on those cards. Which in turn, puts money back in the credit card issuer’s pockets.

If you never use those miles, the airlines just sold millions of dollars of travel to credit card companies that will never get claimed. Don’t do that!

Before they’re willing to give you all those sign-up bonus points, the credit card issuers require some amount of minimum spending. They had to buy those points after all. They need to make sure that they can recoup the cost. How? By ensuring that you have generated a minimum amount of transaction fee income for them before you get your points.

A typical arrangement is a $2,000 minimum spend, which you must complete within 3 months of opening the card. Spend at least that amount in 3 months and you’ll get the 50,000 point bonus. Fall even a dollar short and you don’t. They lured you with the potential for points that you will never get because you forgot to meet your spend requirement. In this case, they earned a bunch of transaction fees and it didn’t cost them anything! So don’t do that either!

Reward travel mechanics

And that’s the modern way that you ‘earn’ free travel. You help the credit card companies generate enough revenue to offset the cost of the points they bought from airlines who have already made money on the travel you book with rewards. How’s that for a complex eco-system!

As an aside, rewards are typically issued to your account when the billing cycle ends. Which is generally every 30 days or so. Once your billing cycle ends, you are issued a statement with your balance due and payment due date. You should always pay your balance on time and in full and never live outside of your means.

Defaulting on balances and not paying on time are two prime ways to hurt your credit score and your financial well-being, and that’s never a good idea, no matter how appealing the points are. You have to pace yourself based on what your budget allows you to pay off right away.