Pretend for a moment that you have just bought a gray sweater from me. It costs $100, and I give you two options in terms of how you can pay.
The first option is to pay me in cash and be done with the transaction—simple enough. Of course, you might not have cash on you; you might not have the cash for the payment at all. In that case, you can delay payment, but there are a few catches.
For each month you delay paying me, you will owe more money than you previously did, equal to roughly 15% for the year. Late payments will also make me think that you are untrustworthy, and I will increase the rate you owe me on delayed payments for future goods. Finally, I reserve the right to tell all my buddies about your untrustworthiness, and they’ll charge you higher rates, too. Sound like fair deal?
For each month you delay paying me, you will owe more money than you previously did, equal to roughly 15% for the year. Late payments will also make me think that you are untrustworthy, and I will increase the rate you owe me on delayed payments for future goods. Finally, I reserve the right to tell all my buddies about your untrustworthiness, and they’ll charge you higher rates, too. Sound like fair deal?
When the terms of credit cards are laid bare and simple, some begin to look a lot less attractive. Of course, a major problem for young people is that credit card deals are confusing and muddled. (Even in researching for the example to begin this piece, I had trouble figuring out how much it would cost to leave a purchase unpaid on my card for a month or two.) People often aren’t aware of their cards’ different fees, and that lack of clarity hinders wise financial decisions. For instance, would you still splurge on a pricey outfit you could not afford if you knew you would end up spending 20-30% more on it than if you waited until you could pay for it upfront? That knowledge would make me at least think twice.
Credit cards can cause unwise financial decisions by making it unclear how much one is spending. But they can also cause consumers to spend more, even when aware of the amount, just by making the cost feel less real and tangible. Consider a study by Drazen Prelec, a professor at MIT, that found that students were willing to pay twice as much for an item when they could pay with credit, as opposed to cash. The study controlled for the possibility that subjects just might not have much cash on them; the high spending was linked to the ease and relative painlessness of paying with plastic. (Of course, the process is only easy and painless until the bill comes due.)
Given these hidden problems with how young people use credit cards, how can they improve their financial decisions?
For one, young people should educate themselves about the different fees and terms associated with credit cards. A great financial resource online can be found here, a series of calculators related to different credit card scenarios. A great credit card glossary can be found here for anybody looking to brush up on their credit card vocabulary. Not all credit cards are evil; learning about what makes a good credit card offer is an important skill.
Second, when making a purchase, consider whether you would choose another option if you had to pay in cash upfront. For instance, if you’re often crunched to pay off your credit card balance, try to determine whether certain choices are contributing to that crunch. Do you tend to splurge at the beginning of the month when you get your credit back? If so, you might devalue the cost of having to repay that money, and your future self is often stuck holding the bill. Do you enjoy the feeling of handing over your card, as opposed to the pain of pulling out cash? Forcing yourself to pay in cash when possible might help restrain your spending by making its impact more visible—fewer bills in your wallet.
Credit cards are undeniably convenient, and they are great financial tools when used properly. If you control your spending and always remember to pay off your balance in full, then feel free to spend away, and maybe even rack up some rewards points. Still, certain elements of credit cards contribute to poor spending habits, and young people should be made more aware of those aspects so that they can reshape their thinking and make wiser financial decisions.
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Photo from above is available here.
Using cash taps into both fear-of-loss effects and our greater facility with physical objects, which definitely help us spend less.
ReplyDeleteThere are two (under-used) features of credit cards which can help trim spending--automated pie charts showing your spending breakdown by category, and the ability to contest charges with a retailer (get your money back with no hassle up to 60 days after the fact if they don't perform--not that common with clothes, but on services or online purchases can save a bundle).
And it's worth noting the easiest way to avoid ever paying late fees or getting your credit dinged for late payment--sent up an automated payment for the minimum (usually something like $10) every month from your bank. This can, of course, backfire if you run your bank balance that close to the line, but in that case you'll probably run into overdraft fees anyway. (And it's worth noting that you're legally allowed to instruct your bank to deny ATM, debit, or billpay transactions rather than overdrafting--doesn't work for check or direct draft, though.)
Hey Ryan,
DeleteGood to hear from you. Thanks for checking out the site!
I think the issue with late fees/running up interest on credit cards is that it often isn't clear that just paying the minimum is insufficient. For example, if you owe $100 on your balance but only pay the minimum monthly payment of $15, you'll still owe interest on the remaining $85. You're absolutely right that you won't be dinged for entirely missing the payment, but it certainly hurts your bank account in the long-run to not pay the entire balance. Just something worth noting that often isn't clear enough.