The Hidden Costs of Gift Cards: How Companies Profit From Your Presents

Introduction

Gift cards have become an increasingly popular gift-giving option over the past couple decades. A gift card is a prepaid card that stores credit and can be redeemed at a particular store or group of retailers. The recipient can use the card's prepaid balance to purchase goods or services at those businesses.

Gift cards appeal to both the giver and recipient. For the giver, gift cards allow them to give the recipient the flexibility to choose their own purchase while still feeling like they gave a thoughtful gift. The recipient gets to pick something they want. Gift cards have become popular for both personal and corporate gifting occasions like birthdays, holidays, weddings, employee rewards, and more.

According to industry statistics, sales of gift cards reached an estimated $200 billion in 2022 in the United States. Over 80% of consumers planned to buy gift cards during the 2022 holiday season. With the rise of digital gift cards that can be purchased and redeemed online, gift cards have become even more ubiquitous in e-commerce. This growing popularity means gift cards have become big business, leading to the creation of a multi-billion dollar gift card industry.

Card Fees

One of the primary ways gift card companies generate revenue is through fees charged to consumers. There are generally two main types of fees associated with gift cards:

Activation fees - These are fees charged when initially purchasing and loading a gift card. Activation fees are generally $3-5 and go directly to the retailer or gift card company. This generates significant revenue given the high volume of gift card purchases each year.

Monthly service fees - Some gift cards charge a monthly service fee after a certain period of inactivity, such as $2-3 per month. This incentivizes customers to redeem their cards more quickly. For gift card companies, it generates steady revenue on balances that have not yet been redeemed. Based on a sample of top gift card companies, monthly fees can generate over $40 million per year.

By charging fees upfront and through ongoing monthly service charges, gift card issuers are able to generate reliable revenue streams in addition to breakage from unredeemed balances. The fees represent pure profit since they require no associated costs. Consumers may not love paying them, but they have become an accepted part of the gift card industry.

Unredeemed Balances

A significant source of revenue for gift card companies comes from unredeemed gift card balances. Industry experts estimate that anywhere from 5-20% of gift cards go unused by consumers. This leaves billions of dollars in unused funds on gift cards each year.

The money from unredeemed cards is considered "breakage revenue" for retailers. Since the expectation is that a certain percentage of cards will never get used, companies are able to recognize breakage revenue on their books after a set period of inactivity, usually around 12-24 months. For example, if someone purchases a $50 gift card but only uses $40 of the balance, after 2 years, the retailer can assume the $10 will never get redeemed and they can book it as revenue.

While exact numbers are hard to pin down, various sources estimate that breakage accounts for anywhere from 10-40% of the face value loaded onto cards. With billions in gift cards sold annually, unredeemed balances represent a significant income stream for retailers. Consumers may forget about old gift card balances over time or lose track of cards, providing a steady source of profits for gift card sellers.

Breakage

Breakage refers to the money left on gift cards that goes unredeemed. When a consumer purchases a gift card, the full value is paid upfront. However, many gift cards are never fully redeemed. The money left unused on those cards is called breakage.

Gift card companies earn revenue from breakage in a couple key ways:

Dormancy fees - After a certain period of inactivity, usually 6-24 months, companies start charging service fees that reduce the remaining balance. These dormancy fees generate income on unused gift cards.

Expiration - Some gift cards have an expiration date, after which the remaining funds can no longer be used. Expired cards with balances are pure profit for the issuer.

Abandonment - Many consumers simply lose old gift cards or forget about leftover balances. This provides a steady stream of breakage revenue for companies as abandoned cards never get redeemed.

The money generated from breakage is significant. By one estimate, roughly $3 billion in gift card balances go unredeemed each year in the United States. With huge unused balances outstanding, breakage has become an important revenue stream for gift card sellers.

Interchange Fees

Gift card companies earn revenue through interchange fees charged to merchants. Interchange fees are a small percentage of each gift card transaction that the merchant pays to the card network.

For example, if someone purchases a $50 gift card, the gift card company may charge the merchant a 2% interchange fee, so $1. The merchant pays this fee as a cost of accepting gift cards.

The interchange fee provides an ongoing revenue stream for gift card companies on every gift card transaction. As more gift cards are purchased and redeemed at merchants, more interchange fees are collected.

Interchange fees are generally 1-3% of the transaction amount. On a $100 billion gift card market, interchange fees can generate billions in revenue for the major gift card companies like Visa, Mastercard, and American Express.

The interchange fee percentage may seem small, but it adds up with the enormous volume of gift card transactions. Consumers are not charged the fee directly, but merchants factor it into their pricing. So ultimately, interchange fees get passed on to consumers through higher retail prices.

Earning Interest on Balances

Gift card companies generate revenue by earning interest on unused gift card balances. When a customer purchases a gift card, the company receives those funds upfront before the recipient uses the card. The company holds these balances in accounts and earns interest on the money over time.

For major gift card companies like retailers and restaurants that sell high volumes of cards, the unused balances can amount to millions of dollars sitting in accounts. These sizable balances allow companies to earn sizeable interest through their financial institutions. The longer it takes for gift cards to be fully redeemed, the more interest companies can accumulate.

Some estimates suggest companies earn an average return of 1-2% annually on unused gift card balances through interest. While not a primary revenue stream, interest provides a modest extra income source by leveraging customer funds held over time before redemption. Along with other revenue sources like fees, interest contributes to the overall profitability model of gift card programs.

Investing Balances

Gift card companies generate revenue by investing unredeemed gift card balances. When a consumer purchases a gift card but doesn't redeem it right away, the issuing retailer gets to hold onto those funds. Retailers invest these balances to earn interest and returns.

The money from unredeemed gift cards is often invested in low-risk vehicles like money market accounts, CDs, and short-term government bonds. This allows retailers to earn modest returns on the balances while keeping the money relatively liquid and safe in case a large number of gift cards are redeemed at once.

According to one estimate, retailers earn around $2 billion per year or more just from investing unredeemed gift card balances. The returns vary based on the size of the retailer, how much they have in outstanding gift card liabilities, and prevailing interest rates. But overall, investing balances provides a sizable revenue stream for major gift card sellers.

Consumers may not realize it, but when they purchase a gift card and don't use it quickly, they are essentially providing an interest-free loan to the retailer. Savvy gift card companies take advantage of this float to bolster their bottom lines. While gift cards remain popular and convenient, the undisclosed interest earned off balances is one of the perks for retailers.

Partnership Revenue

Gift card companies generate revenue through partnerships with major retailers, restaurants, and brands. One lucrative partnership opportunity involves co-branded gift cards. For example, Starbucks may partner with Visa to issue a Starbucks gift card that also acts as a Visa prepaid card. The gift card company shares in the revenue from these co-branded cards.

Gift card companies also earn commissions when they partner with retailers as authorized resellers of branded gift cards. For instance, a grocery store may have a gift card rack filled with restaurant and retail gift cards. The gift card company supplies these cards to the grocery store and receives a commission on each card sold. The revenue split varies, but the gift card company may receive around 5-10% of the face value as commission.

By partnering with major brands, gift card companies are able to expand their distribution and product offerings. These partnerships provide another significant revenue stream through shared card fees, commissions, and branding opportunities.

Float

Gift card companies generate revenue from the float, which is the time between when the customer pays for the card and when the gift card is actually used. The money paid for gift cards sits in the company's account until the gift card is redeemed, earning interest for the company.

The longer it takes for a customer to use a gift card, the more interest the gift card company earns on the balance. Even after a gift card is partially used, any remaining balance continues to earn interest for the company as it sits unused. This provides an ongoing revenue stream for gift card companies in between the time the card is purchased and fully redeemed.

Some companies try to extend the float period as long as possible to maximize this revenue source. They may make it difficult to check balances online or use only part of the card value, as barriers to full redemption. The float enables gift card companies to earn interest on billions of dollars for months or even years at a time across their unused gift card balances.

Conclusion

Gift card companies are able to generate significant revenue through a variety of methods. A key way is by collecting fees from consumers who purchase the cards. These include purchase fees, activation fees, monthly service fees, and more. Companies also benefit from cards that go unused and never get redeemed. Known as breakage, a percentage of gift card balances remain on the books each year.

Interchange fees from card networks give issuers a small percentage every time a gift card is used. Interest on outstanding balances also produces income. Some providers may invest the cash backing gift cards to earn returns. Additional revenue can come from partnerships with retailers and brands. The time between when consumers load funds and the recipient spends the balance, known as float, allows companies to earn interest.

In summary, while gift cards may seem simple, there are many complex channels gift card companies leverage to drive profits. Their various fee structures coupled with unused card values enable billions in revenue annually. Consumers may not realize the full scope of how these popular prepaid cards deliver earnings.