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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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2. POISONED CARROTS
One of the oft-cited reasons for using credit cards (and why so many people simply “love” their credit cards- their words, not mine) is the carrot of rewards, usually in the form of cash back or airline travel miles.
And on the surface, this rationale seem perfectly justified. It goes something like this:
Credit cards can be used for just about everything, and there are certain things you have to spend money on every month: food, clothes, rent, etc. The credit card company offers you rewards for using the credit card, so if you’re going to be spending this money anyway, you might as well get some free stuff in return for your patronization, right? And if you pay off your entire balance every month, there’s no harm to you; just some free cash or travel!
This is a fairly straightforward rationale that on the surface seems like a no-brainer. Unfortunately, it is full of false assumptions and ultimately is a win for the credit card company and a loss for the consumer.
A. STICK IT TO THE MAN
For whatever reason, there is this curious notion that if you don’t ever carry a balance or pay interest, you are somehow sticking it to the credit card company. A couple of examples:
NEVER, ever carry a balance from one month to the next. If you do, cut the card. If you don’t, you’re never using your own money for anything. The credit card company might hate you, but so be it. (Forget Dave Ramsey, 5 Ways I’ve Used Credit Cards to Better My Advantage, 20somethingfinance.com)
Firstly, Johnny and I don’t use credit cards the way that credit card companies intend them to be used. At the end of each month, we pay our entire balance. As a couple we’ve never paid a penny of interest on a credit card. (WHY WE USE CREDIT CARDS OR WHY DAVE RAMSEY HATES OUR GUTS, ourfreakingbudget.com)
Me not using credit cards would actually have the opposite effect. By weeding out their responsible cardholders, all they’d see is profit. So if anything, mooching the rewards off credit card companies is a way of attacking their business model. (ibid.)
I call this notion curious because it not only misunderstands how credit card companies make the bulk of their money, but also because it tends to encourage spending habits that are exactly the type of spending habits that credit card companies desire of their users.
Contrary to popular belief, credit card companies do not make most of their money off of interest. Rather the vast majority of their money is made off of transaction fees which are charged every single time a credit card is used to make a purchase. This shouldn’t be that surprising; after all, there are millions of people making billions of purchases every year with their credit cards, and the credit card companies get a piece of each of those transactions.
The irony, of course, is that the people who advocate using your credit card on absolutely everything you can so you can get more rewards and stick it to the credit card companies are actually doing the credit card companies’ marketing for them, and doing exactly what the credit card companies want them to do. After all, the more transactions you make with your credit card, the more money they stand to make.
Seen in this light, the rewards are actually only a rebate of sorts on the transaction fees incurred (which retailers add into the cost), which means that the more you spend with your credit card, the more ultimately the credit card company makes and the more customers have to spend.
B. GET THOSE FREE REWARDS!
But even if you don’t care about sticking it to the credit card companies, why wouldn’t you get the rewards for buying what you are going to buy anyway? Would you not ultimately still come out ahead if you used credit cards responsibly without carrying a balance or paying interest?
The problem with rewards is that they are what I like to call poisoned carrots. That is, they are ways to get you to use debt as much as you can, all under the guise of somehow getting something for nothing.
One major difficulty is that the rewards are admittedly fairly pathetic when one actually gets down to them. I’ve outlined why this is the case in several blog posts, and the bottom line is that the potential rewards are simply not comparable to the real risk and realistic costs.
After all, as seen in the first section, it is very likely that you are going to end up spending 12-18% more with a credit card than with cash. This tendency, of course, can be amplified when you think that using a credit card frequently can gain bigger rewards. While you might be optimistic and think that you will not fall into spending more with a credit card than with cash, once again this assumes a flawlessly best-case scenario for every single interaction with debt, which is- if we would be honest- an extremely naive notion.
Even otherwise sound financial advice can be blinded by the glitter of rewards. Consider the following:
Use credit cards strategically. There are 5% cashback gas cards and 6% cash back grocery rewards cards. (Forget Dave Ramsey, 5 Ways I’ve Used Credit Cards to Better My Advantage, 20somethingfinance.com)
6% cash back on groceries (up to a predetermined limit, naturally) seems like a fine thing; in the example from this site a single person on a $3600+ food budget could receive $217 cash back annually (minus credit card fees, of course…). However, this calculation does not include a reality assessment either of risk or of the tendency for overspending relative to cash. If we went with even an extremely conservative estimate of 12% extra in spending with a credit card, on a $3600 food budget one would end up spending an extra $432 relative to cash, which means that using a credit card on all of one’s grocery spending would cost an extra $215 a year, plus the credit card annual fee (if applicable).
Seen in this light, of course the credit card company is going to try to entice you to use your card as often as possible, and hold out rewards for its use as a way to encourage further use. And if you are already accustomed to using a credit card for everything, then cash back is then another way for the credit card company to make money.
Travel is often an even bigger enticement, usually because travel miles can signal within one’s mind the notion of a free or nearly free vacation, simply for using a credit card on what one would normally buy. And no doubt in many cases one might actually manage to rack up enough miles to obtain a “free” flight.
However, I always find it instructive- especially when someone is offering me something seemingly for nothing or for little effort- to ask exactly what they expect to gain out of it. Naturally, because travel is popular it is a popular reward, but it also is a way for the credit card companies to make even more money off of you.
After all, it is hardly a controversial notion that when you travel you end up spending more on things than you do when you are at home. As an example, cooking isn’t always easy or available when traveling, and so eating out is a much more accessible and tempting option. And of course, if you are in a new locale, you hardly needs much prodding to sample local cuisine, especially if your card gives you a kickback on dining out!
This doesn’t even take into consideration that travel rewards can be notoriously difficult to redeem, nor that there are trillions of unredeemed miles. It should also be noted that airlines can change the terms and value of the miles at any time without warning, making this reward a rather dubious one.
Now, there’s nothing wrong with spending money on these things when you travel, but the point is that travel is given as a reward for credit card use because it is very likely that the travel itself will encourage further spending and card use.
Indeed- you may even rationalize a trip you didn’t intend to take because you have miles and a “free trip” available.
Thus, the rewards in each case are actually enticements to not only use your card more in the course of normal spending, but also to encourage further spending precisely because of the rewards received. For the consumer, the rewards can seem like a substantial amount, but when compared with not only the usually high annual fees for “good” rewards but also the average percent of over-spending with a credit-card, the net result is a negative one.
In other words, you will end up spending money to get those “free” rewards.
The psychological mechanism behind these sorts of incentives is powerful; even those who recognize it and have researched it can fall under its spell:
But the most surprising thing about these studies? When I tracked down many of their authors this week, I found that they, too, can’t quite kick the credit card habit. Why doesn’t Joydeep Srivastava, co-author of the Monopoly money study, use a debit card or cash?
“Mostly because my credit card is giving me lots of miles,” he said. (The Most Serious Threat When Using Credit: You, Oct. 10, 2014, nytimes.com)
Priya Raghubir, Mr. Srivastava’s co-author, happened to be moving to New York City when their research was published in 2008. “I’ve never in my life been in greater debt,” she said, laughing at the memory now. “I knew all about how credit cards work, but it wasn’t my fault. All you need to do to take a taxi here is swipe a card.” (ibid.)
Once upon a time Mr. Prelec, a professor of economics at the Sloan School of Management at the Massachusetts Institute of Technology, refused to collect frequent-flier miles (or even coffeehouse stamp cards) because he thought they cluttered his decision making. When he began to have second thoughts, he still resisted collecting miles for a while longer because it might remind him of all of the free trips he had already missed out on.
Now, he doesn’t leave home without his … wait for it … American Express card. Why not go debit-only? “The rational answer is, it’s the points,” he said, given that few debit cards offer reward points. He redeems Amex’s Membership Rewards points for free travel. (ibid.)
As I’ve been writing this post, Megan gave me an interesting anecdote from her own experience this week. She noticed that some online account had accumulated X number of points, and that she only needed to spend X number of dollars more to get an Amazon gift card. She mentioned that for a moment the thought of that “free” gift card prompted her to consider actually spending money on something just to get the gift card. She told me that a moment later she realized what was happening and exactly how powerful the allure of “free” stuff is to us all, especially if it seems to cost us nothing or occurs in the course of our normal lives.
The biggest problem with the poisoned carrots is that they can lull us into this idea that we can get something for nothing, and that- following the best-case scenario script that the credit card rationalization lives on- we can ultimately come out ahead with little to no effort. But this is precisely the sort of attitude that credit card companies are banking on, for all of these calculations leave out the tremendous amount of risk that is undertaken every time you swipe your card.