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I’ve written many times before about some of the dangers and traps associated with the use of credit cards. But an article (with some interesting Facebook comments) that Megan sent me about a new credit card program with super-OMG!-amazing sign-up bonus features got me to thinking about the psychological effects of using credit cards and why we find them so hard to get rid of, yet so easy to rationalize.
I hope to make the argument that the rationales for the use of credit cards ultimately rely upon thinking primarily in terms of a best-case scenario and rarely take into account the substantial risk entailed by their use.
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1. YOU WILL SPEND MORE
Numerous studies have shown that those who use credit tend to spend more on items relative to those who spend with cash, somewhere between 12-18% on average. The reasons for this are multifaceted, but there are some broad stroke reasons underlying this:
Paying for something with cash tends to associate the pain of parting with that cash with the item purchased. Thus, if you have a finite amount of cash in hand (or funds available in one’s account), each purchase tangibly reduces that amount in hand, which is psychologically associated with pain. Due to this, users of credit cards tend to focus in on the benefits of the item purchased, whereas cash-based spenders tend to focus more on the costs.
Of course, no one actually sets out to intentionally spend more using credit than cash, and most of us probably think we end up spending the same amount. However, the research has shown that this simply isn’t the case, and also carries over into debit card use to some extent, as swiping plastic is less painful of a purchasing mechanism than cash.
In my own spending habits I can see how this dynamic works. For example, sometimes I go to the grocery store to pick up specific items for something Megan is making, or maybe just for some items we have run out of. She has a much better idea of the costs than I do, but even I have a fairly reasonable idea of what the costs for those items will be. However, I almost never shop with cash, instead using my debit card. Let’s say I am picking up around $30 worth of groceries. I get all the items in the cart and they are probably close to that amount of money. But as I get near the checkout line, I begin to think about how I’m going to have a late night of work, and so I might need some caffeine to help me stay awake, and so I pick up a Diet Coke. Granted, it’s only $1.69 (so I tell myself), and isn’t that big of a deal. Plus, I know that we have more in the checking account than we need for these groceries, and so that extra expense (plus the freeze pops I wanted, and maybe some gum…) isn’t really going to matter. As I checkout, the bill creeps up to $37 or so, but hey, it’s only $7 more, so I swipe with my debit card and think nothing of it.
Of course, had I had only $30 in cash, I couldn’t have made the extra purchases, or I would have had to think more carefully through the costs and benefits associated with each item.
Granted, in this scenario the overspending is somewhat related to my lack of self-control, but the crucial point is that this lack of self-control in spending is itself facilitated not only by being able to swipe the plastic, but also because of little decisions like these over many years and thousands of purchases. In fact, most of the time I’m not even thinking about it, and very rarely recognize how the card and its convenience means that I end up spending more than I intend to, although no doubt I would argue that I don’t.
Now, with the debit card there is obviously some of this dynamic of the tendency to overspend, but it is somewhat mitigated by being attached to actual money in an account. Megan has our account tied into Mint.com and we can see exactly what is being spent on what and how that relates to a budget for each category. As an example, I have X amount of money allotted for my own personal spending each month. When I go to use the debit card on something (or make the purchase online, which happened most often), I have to feel the pain of watching that budget deplete immediately, and thus have to more carefully weigh the benefits of what I want versus the cost of that item.
B. COGNITIVE ILLUSIONS
Firstly, a higher credit limit can lead one to think one has more spending power than one has. After all, the credit limit is often wholly unrelated to the amount of actually available funds at any given time, and thus it is relatively easier to purchase items using money that is not currently extant. As explained in the article Why We Overspend on Credit in Psychology Today (without any apparent sense of irony):
When used responsibly, credit cards are a valuable financial instrument. They are generally more convenient to carry and use than cash, and they allow consumers to “smooth” consumption over time (borrow from the future during lean times to maintain a constant standard of living). (Why We Overspend on Credit, Psychology Today, June 22, 2013)
It is this “borrow[ing] from the future” which is problematic, since the consumption is predicated on the best-case scenario of the future earnings occurring (and perhaps even increasing) in the future. Left out of this equation, of course, is the possibility that the future funds may- for whatever reason- come up short or not be available to cover the spending. Due to this, advice like the following becomes rather frightening:
Every six months, ask your credit card company for a credit limit increase of a few thousand dollars. You will never need to use these increases, but it will lower your balance to credit limit ratio, which will do wonders for your credit score. (Forget Dave Ramsey, 5 Ways I’ve Used Credit Cards to Better My Advantage, 20somethingfinance.com)
Of course, the intention would never be to use these increases, but now the temptation exists and, if not tempered by extraordinary discipline, affords one the opportunity to make a bigger financial mess every six months, even if it is unintentional. Implicit in this advice is that raising one’s credit score is somehow a meritorious action, although that reason is not specified. A credit score, however, is fundamentally an indication of one’s interaction with debt, entailing that to have a better credit score one ultimately has to use debt in one form or another. Yet the purpose of good credit is to be able to interact with even greater levels of debt (ostensibly on terms more advantageous to the borrower), which means that this sort of rationale is ultimately self-defeating.
And, of course, the more interaction one has with debt (especially credit card debt), the higher the likelihood that the best-case scenario will not work out, and a financial mess will happen.
Secondly, higher credit limits can “signal future earnings potential… and these expected earnings can make prices seem relatively small, which in turn stimulates spending.” (Why We Overspend on Credit, Psychology Today, June 22, 2013) In other words, the more one can spend, the more successful one may consider (or expect) oneself to be, which means that the money spent is not necessarily based upon current earning potential but rather upon a false sense of success. This is also coupled with an often underestimated sense of risk and over-estimated idea of the best-case scenario, which only further buttresses the rationalization.
Ultimately, what higher credit limits tend to do is to make purchases appear relatively less significant compared to the same purchase not procured with credit. The reason is that one often tends to have a higher credit limit than available cash for the same purchases, which skews the perceived cost relative to each payment method.
For example, in my previous illustration with the groceries, an extra expense of $2 within a $30 available cash budget is far more significant than the same $2 within the same $30 budget but with far more available funds. True, I may be extremely disciplined in my spending, but the plastic method (even with debit cards) makes the expenditure feel far less significant than the cash-in-hand method. However, with the debit card that money is immediately withdrawn from my available funds, whereas with credit the immediacy of the payment is removed and this time lag between purchase and payment contributes even more to the lessened psychological impact of the purchase relative to the cost.
To continually increase credit limits as a matter of course- per the advice noted in the previous section- is obviously fraught with peril, for the ease with which a financial mess can ensue is increased.
Unfortunately, the best-case scenario calculations within which these sorts of credit rationalizations are made underestimates both the cumulative effect of time on decisions, discipline and the like. After all, if I only have cash, there is a finite amount of financial mistakes I can make at any given time, relative to the amount of money I currently have. However, if I am trying to continually “smooth” consumption over time based on future earnings, the size of financial mess is compounded in relation to the amount of consumption, since the smoothing of consumption will often be made to make up previous shortfalls, to acquire that which one does not have the cash to buy, or to avoid spending in the present so as to use that cash on something else.
The bottom-line is that credit cards are meant to make buying things as painless as possible; unfortunately, it is precisely that pain which is what is often needed to help discipline spending.