Visa gift cards cost more than store gift cards because the profits from each are derived differently.
Why Do Visa Gift Cards Have Activation Fees?
A question I’m frequently asked is, “Why do Visa gift cards have activation fees when store gift cards are free?”
The simple answer is that stores predominately make money when customers redeem their closed loop gift cards for service or merchandise. General use gift card providers, on the other hand, make money by providing the gift card itself.
Below is a detailed explanation of how stores and other businesses make money from their gift cards.
5 Ways Stores Make Money From Gift Cards
To set up a gift card program, a merchant has to buy plastic gift cards, a gift card display of some sort and signage to let customers know that gift cards are available. The merchant also has to integrate the gift card program into the store’s payment processing system so that when a gift card is swiped or the card number is entered, the cash register will accept the card as payment. There is also some banking involved as merchants have to hold funds received from gift cards in a separate account. Finally, savvy retailers also need to add electronic gift cards to their website and allow customers to redeem these egift cards both in stores and online–requiring additional programming and integration.
Depending on the size of the merchant, the cost to set up a gift card program can range anywhere from a few hundred dollars (think downtown doughnut shop) to several million dollars (think national chain store). This investment, however, typically pays for itself because stores profit from their gift card programs in the following ways:
1. Both the Giver and the Receiver Visit the Store or Website
Although gift cards can be purchased in a number of locations (online, in grocery stores, at gas stations and so forth), many people still prefer to buy gift cards at the stores in which they will be redeemed.
Martha Weaver, former Director of The Gift Card Network in 2014, said that “in-store were up slightly and still generally the biggest channel for card distribution” among big box retailers, grocery stores, gas stations and department stores. Thus, by having an in-store gift card available, the store creates an opportunity for gift-givers to venture in and possibly buy more than just a gift card. The second shopper is, of course, the person who receives the gift card…unless the person buying gift cards is only doing it to earn gas points.
2. Gift Card Recipients Become New Customers
Some people prefer to give gift cards to stores and restaurants they know their friends and family members frequently visit. (A good practice, by the way, if you want to ensure the gift cards will get used.) Other people, however, like to push gift recipients in new directions by giving gift cards to less-familiar merchants such as a new restaurant in town or the gift-giver’s favorite boutique.
A study by First Data showed that “11% of gift card receivers noted they had never or rarely visited the merchant’s location” before receiving the gift card and over a third changed their purchasing behavior in order to redeem the card.” Just two years later, a 2014 study by First Data said, “51% of respondents said that receiving a gift card prompted them to visit a store more often than they would have otherwise.”
Gift cards are more than just convenient gift-giving options. With the right program and incentives, they can be highly-effective at driving in new foot traffic.
3. People Overspend the Value of Their Gift Cards
Customers with gift cards to redeem are motivated shoppers. They have what might feel like “free money” in their wallets and they are ready to spend it.
A 2014 study by CEB TowerGroup reports that 65 percent of gift card users overspend the face value of their gift cards by 38 percent. Respondents in the 2014 study by First Data (referenced above) said that they spent an average of $23.41 beyond the original value of the gift card–an increase from $20.79 in 2012. The 2012 First Data study also reported “72% of gift card shoppers spent more than the original gift card value when redeeming their cards, 25% purchased an item they had not planned to spend money on, 8% bought a more expensive version of an item they already planned to buy, and 3% purchased an item from a store they don’t normally shop at for such an item.”
Blackhawk Network published a new consumer gift card study that says, “59% of consumers surveyed usually spend more than the card’s value.”
In short, stores make money when customers redeem their gift cards, often overspending the value of the card on products that have a much higher profit margin than the plastic itself.
4. Gift Card Sales Create a Positive Cash Flow
When a gift card is first sold, the merchant receives money from the customer and essentially gives either a plastic or digital “I owe you” for service or merchandise in return. Money comes in, but inventory doesn’t leave the shelves. Unless store policy allows for it (which is rarely the case), the consumer cannot return the gift card for a refund resulting in a positive cash flow for the business.
5. SOME Stores Make Money from Breakage
In the early days of gift cards, a store could issue a $25 gift card, start charging inactivity fees a couple of months later and deplete the value of the gift card before the recipient remembered he had tucked it into his wallet. That cash cow went out to pasture in 2009, however, when the Credit Card Accountability Responsibility and Disclosure (CARD) Act passed.
Federal law now says that closed loop gift cards cannot expire in less than five years and non-use fees may not be charged in less than one year of inactivity. Some states have enacted even tougher restrictions. In California, for example, store issued gift cards never expire and stores may not charge dormancy fees either. (Though state gift card laws vary, many national merchants have simply adopted a “no expiration, no fees” policy across their stores. Target gift cards, for example, say “No fees. No expiration. No kidding.®”)
So what happens to the money obtained from gift cards that never get redeemed (also known as “unclaimed property”)?
According to the National Conference of State Legislatures, “federal law creates a floor for regulation and leaves room for state regulation on redeeming gift cards for cash and unclaimed property provisions.”
So despite the notion that stores always profit heavily from unused gift cards, sometimes that breakage goes to the government instead. In Alabama, for example, gift cards are presumed abandoned three years after June 30 of the year in which the gift card was sold and 60 percent of the card’s face value must get turned over to the state. Alaska has a similar three year policy (without the June 30th date), but will happily collect the full purchase price of the gift card. Arizona says gift cards are not considered property and are not subject to the unclaimed property process.
Summary: Store Gift Cards Are Great for Marketing
Although breakage from unused gift cards may have initially been the most profitable piece of the gift card puzzle for stores, merchants now appear to benefit more (and have less math to do) when gift cards are used to bring in shoppers, obtain new customers and increase sales of tangible goods.
As a result, the gift card has become more of a marketing tool for these businesses than a straight income producer.
Stores may not make as much money off the gift card itself as they originally did, but they can still bury the cost of the program in merchandise markups so customers pay for the “fee free” gift cards without really knowing it. Companies that sell Visa gift cards, on the other hand, are in the business of making money directly from the card itself, and because they can’t mark up the price of the gift card (like a store does with a blouse or a crockpot), they charge activation fees to cover product costs.
3 Ways Bank-Issued Gift Card Providers Make Money
Visa and Mastercard gift cards can be used wherever Visa and Mastercard debit cards are accepted–online, in stores, over the phone and so on. Because these gift cards are open loop, meaning they can be used almost anywhere, the businesses that issue the cards can’t lure customers back to their sites to redeem and overspend their gift cards on merchandise like a store would. Instead they derive profits from providing the gift card itself. Doing so costs us money and is, therefore, not free to the consumer either.
Though the rates each company charges may vary, businesses that sell general use gift cards, whether they’re powered by Visa, Mastercard, Discover or American Express, make money in the following ways:
1. Keep Small Portion of the Activation Fee
In order to issue gift cards to the public under the Visa or Mastercard brand names, an open loop gift card seller must print physical plastics and gift card carriers that clearly explain the terms and conditions associated with the cards. (The credit card company does not supply the finished product–just gives permission to make and sell it.) The seller also has to partner with a sponsoring bank as an Independent Sales Organization (ISO). The ISO charges the gift card provider a fee every time a gift card is activated through their network. In addition to the ISO, a debit card processor charges another fee for providing card processing services. Lastly, customers pay for gift cards with debit or credit cards which means the seller must also pay a merchant fee (a payment processing fee) which is a percentage of the dollar value of the gift card purchased.
Thus, providing an open loop gift card–one that is flexible enough to be used at nearly any payment processing machine across the country–costs much more than the face value of the gift card.
Open loop gift card sellers pass this accumulation of fees onto the consumer with one up-charge called an “activation fee.” Any difference between the activation fee and the accumulated fees, albeit miniscule, would be profit.
Here’s a picture that helps explain how Visa gift cards differ from store gift cards.
2. Charge Non-Use Fees and Receive Breakage If Card Not Used
Again, thanks to the CARD Act, the minimum expiration period for an open loop gift card is five years. After the gift card has been inactive for 12 months, a monthly fee can be charged against the balance until the card reaches a $0 balance or the card becomes active again. At the expiration date, any breakage will either escheat to the state or become the property of the gift card provider, depending on where the gift card provider’s place of business is located and a number of other factors relative to the business itself.
3. Receive Portion on the Merchant Fee
When a customer uses an open loop gift card to purchase goods or services, the store or restaurant is charged a merchant fee for accepting the card. (This is the same merchant fee the seller paid when the customer initially bought the gift card with a debit or credit card.) The credit card company, the ISO, and the gift card seller all get a percentage of the merchant fee charged on the sale.
Summary: Bank-Issued Gift Cards Mostly Profitable if Not Used
In the end, Visa gift cards cost more than closed loop gift cards because the costs associated with them can’t be added to the purchase price of the product without the customer knowing. If you buy a $40 blouse at a store, for example, the retailer will have marked up the price of the blouse to cover operating costs, merchant fees and so on. If you buy a $40 store gift card, the retailer either eats the cost to get it into customer hands easily or slides it into the markup of other merchandise. But a $40 Visa gift card costs $40 to produce plus the fees assessed by the other parties involved and it may not be (probably won’t be) spent at the same place it was purchased. Thus, the gift card provider passes those charges to the consumer in order to cover the cost of making the gift card available.
Perhaps it’s easier to think of the activation fee as the cost of flexibility–the dollar amount you pay for the convenience of getting to use your gift card wherever you want. That’s how I tend to think of it, anyway.
Got More Gift Card Questions?
Please let me know if you have any additional questions or think I missed something here. I’ve been studying the gift card industry for years and I still find some of these details to be a bit murky. Let me know in the comments below or leave a message for Twitter (@GCGirlfriend) or on Instagram (@Gift.Card.Girlfriend).
Happy Gift Carding!
~Shelley Hunter, Gift Card Girlfriend