It’s A Trap!

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One of the of hidden places on the internets to find hilarious things is any kind of tech forum. The level of amusement is directly proportional to the level of fanboy-dom present, which makes any sort of Apple-related news site a veritable treasure trove of instant entertainment.

This particular species of jocularity is generally marked by poor syntax barely masking ignorance, and once the already tenuous link to technology is abandoned (usually after the first comment), it’s time to make some popcorn and enjoy the show.

One particular commenter decided to delve into matters financial, and began- in sublime internet fashion- to opine on something he was obviously not terribly familiar with.

Because where else then on a tech forum would you look to plan your financial future!

Let’s take a look at this hidden nugget of wisdom:

I don’t understand why anyone in the US, unless they cannot get a credit card due to poor credit, would choose to use a debit card over a credit card. Better points, better protection, and you get about a month’s worth of free float. Just keep paying off your credit card online as soon as it reaches 10% of your credit limit, and it will start improving your credit too.

Now, I know that this is basically swinging at extremely low-hanging fruit, but I thought this concept of the ‘free float’ was kind of interesting. A terribly bad idea, but interesting nevertheless.

The idea here is that instead of having your money on the line for the normal purchases you might make, you take advantage of the lag time between when you pay for something with a credit card and when you have to pay it off. Typically, this is about a month, so conceivably you can get this- *ahem*- free month of float money where the credit card company is financing your purchases.

The key to this financial game is to actually pay off the balance at the end of every month. That way no interest is charged and you haven’t had to put your money on the line. Some argue that you might actually be making money since the money in the bank is earning interest, but the standard savings account return (at present) is so minuscule as to be effectively negligible.

The problem with the free float, however, is that it’s really more like playing roulette, since the whole scheme leaves out one of the most important financial considerations: risk.

Let’s say you have a monthly expense budget of $5000. You presumably save $5000 and tuck it away in the bank, ostensibly allocated to pay off the credit card balance at the end of the month. You then float that $5000 on the credit card for those expenses, relying on that money in the bank to be able to pay it off before interest begins to accrue.

The difficulty lies in the presumption that you will 1. be disciplined enough to actually use that $5000 for the credit card balance 2. not suffer any setbacks that might require that $5000 for something else.

If there is one bad month and that $5000 needs to be used for an emergency (say, getting a replacement vehicle so you can get to work), all of a sudden the credit card balance will not be able to be paid off. The next month you could conceivably pay it off with another $5000, but that would only bring you even with the balance and leave you no additional income to pay for the normal monthly expenses. That’s assuming, of course, that you don’t have to use that money on those monthly expenses, which means that attacking the balance will now require money over and above the monthly expenses that were floated on the credit card.

So what seemed like a free float month can very quickly turn into getting behind on balances and watching interest build up.

But what about the points! What about all those travel miles you can accumulate just for using a credit card for what you are going to buy anyway?

Whenever someone is offering me something for free or for very little effort, I find it incredibly helpful to ask myself what they are planning to get out of it. The reality is that credit card companies are very good at making money, and very good at getting people to buy their product. It can seem like they are offering to give you something really good (credit, which many think means ‘free money’), but in fact they are selling you a product; in this case, debt.

And it’s a product they stand to make a very good return on. Firstly, there are the credit card transactions fees that they receive from merchants. The reason the credit card companies try to entice customers with points for buying things they normally buy is that it is in the credit card company’s best interest for you to use their product as often as possible, as should be obvious. Points, miles, cash back; these incentives are merely the lure to get you to use their product on everything.

Of course, then there are the massive APR’s, which for any other product we would immediately think someone crazy for utilizing. The high APR- while certainly offering a potentially lucrative return on a loan- also has the psychological effect of making one prioritize the payments on the credit card, since it seems intuitive that debts with the highest interest rate should be paid off first. And while the corporate line is no doubt that sure, you should pay off your balance at the end of every month, the actuality is that it is also in their best interest for you to miss payments here and there, to get behind and thus remain entrenched in the debt. In fact, given most people’s lack of fiscal discipline, it doesn’t seem to far of a stretch to state that they are counting on a certain level of monthly default.

Why else, one might wonder, does the APR get higher for those who are at greater risk for default?

After all, once you get behind, it becomes very easy to rely upon credit cards to not only buy what you were already going to buy anyway, but also as the only way you can buy those things at all. Once you start having to make payments on the debt you lose that much more of your income, and sometimes the only way (or so it seems) to make up the shortfall is with more credit card purchases. It becomes very easy to get into a situation where minimum payments are all one can afford, which makes the credit card cycle seem nearly interminable.

But hey, at least you’re getting those points and cash back and travel miles! Surely financial slavery is worth that, right?

The really pathetic thing is that the incentives offered for the use of their products are so equally pathetic that these incentives are one of the more oft advertised and argued reasons for using a credit card as often as possible. I was reading an article about floating a credit card and saw this rationale:

My best example is my own. My wife and I opened a credit card about 2 years ago. This August we will take a trip to New York, and one of our plane tickets will be paid in full from our reward points, and with a little left over. Now you can say oh that’s only $350 for a round trip ticket over two years. I say to that, I didn’t do anything but use my credit card and pay it off each month to get it.

Really? $350 over two years? Sure, I wouldn’t stop somebody from giving me $175 a year, but the key here is that this paltry return is not being given something at all; in fact, the credit card companies are counting on you actually spending more than you normally would with cash. Your have to spend an insane amount of money to even get within striking distance of the perk caps, and then you get a pittance in return.

Lovely.

Let’s run some quick numbers here on the $350 scenario. Considering that this credit card has been used for two years, that is $350 over the course of 730 days, which means the use of the credit card in this scenario is earning approximately $.50 a day.

$.50 a day. Really racking up the cash there…

Now let’s imagine you spent $30,000 on regular expenses each year for those two years, buying the things you would normally buy with the credit card. This would mean that you had to spend over $60,000 to get a $350 plane ticket, which is less than 1% of what you spent so as to get that free plane ticket.

But the reality is that- statistically speaking- you will spend far over and above that $175 every year simply for the convenience of swiping the card and the lack of emotional connection to the money. Some studies have shown that people spend 12-18% more on purchases with credit cards than with cash. Let’s return to our scenario. If your normal yearly expenses were $30,000, then you are likely to spend $3600 to $5400 more than you would with cash.

And with all your ‘rewards’ points you stand to ‘get back’ $175.

Sounds like a phenomenal deal! All you have to do is spend an extra $7000+ to get a $350 plane ticket! Who wouldn’t want to sign up for that?

Now, it’s true that with some credit cards you can conceivably ‘earn’ considerably more over that same 2 year period of time; in a previous entry I looked at some which could potentially generate $800 or more in ‘rewards.’ However, in that scenario one would have to spend over $60,000 to get the $800+ cash back. The $800 sounds like a lot of money, but when placed into context it represents less than 1% of one’s total income. The trap, of course, is that the only way you can get these rewards is to take on an enormous amount of risk, which can come back to bite you if you are undisciplined or even if something out of your control happens, which is only exacerbated when your form of payment entices you to spend more than you would otherwise.

Given this painfully obvious reality, it is little wonder that credit card companies try to throw as many points and perks and travel miles as they can at you, since they stand to get you to spend an average of 15% more than you would without them. And if you add up all the transaction fees that exist within that percentage range, as well as the ease with which one can get behind on payments and begin to service the debt, there is a lot of money to be made on getting people to use a credit card on the things they normally buy. 

And all they have to do is over you really crappy rewards.

A nice cozy little trap.

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Jason Watson

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