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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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3. RISKY ROADS
Credit card companies may not make most of their money on interest, but credit card debt is a very real problem for a lot of Americans. The average outstanding balance is not easy to determine, but for those with credit card debt the average is around $8200 for cards that usually carry a balance (according to Experian), whereas other sources put it at somewhere north of $15,000 (NerdWallet).
Often times the advice offered for credit card use is to take advantage of the “free” monthly “float” of funds that the credit card (and its ideal monthly payoff) represents. It works like this:
Say you have $4000 in expenses each month. With a credit card, you can basically “float” that $4000 on the credit card until the money comes in, and then at the end of the month you can make the payoff, having accrued no interest. The ostensible advantage with this system is that your money is not on the line during the float interim, and you get the equivalent of an interest free loan each month (since of course you’re always going to pay it off!).
Some people will also try and use the same strategy in respect to larger purchases by means of a 0% introductory rate on new credit cards. For example, opening a new credit card account may yield a 15-18 month 0% APR period, which, like the monthly free float, can seem on the surface to be an interest free loan for the period. The rationale is that you could make a larger purchase now on this introductory period float and essentially get a free loan as long as you make the payoff before the 0% period expires.
Of course, this can be taken even further if one makes a balance transfer to another new card with another period of 0% APR. To be sure, there will probably be a 3% or so balance transfer fee, but it may seem preferable to pay 3% to extend the 0% loan, since it would beat the beginning of a 16%+ rate on the outstanding balance, especially for larger purchases.
The difficulty with these rationales, of course, is threefold:
A. Risk is not factored into the calculation
B. A best-case scenario is assumed for every step of the process
C. Opportunity costs are not determined alongside risk
A. RISK IN THE MATHS
Any loan represents a level of financial risk, but credit cards can be especially troublesome. This is not only because they tend to have high interest rates, but also because the types of items they are used to purchase tend to primarily be items that are either consumed in their use or quickly lose a bulk of their value.
As an example, let’s say you have a 15 year mortgage of $175,000 at 3.5%. This loan amount certainly constitutes a higher level of risk because of the amount, but the asset it represents (the house) will have a tendency- all things being equal- to increase in value over the life of the loan. Thus, the risk is somewhat mitigated (although not obviated) in that the house has a higher likelihood of being able to be unloaded if necessary without substantial loss and will likely be worth more years later. (This will of course have a lot to do with the amount of equity relative to the loan and other factors.)
The types of items one normally purchases with a credit card, on the other hand, are usually either consumed in their use or lose much of their value immediately upon acquisition. For example, if you follow many people’s advice and use a credit card on the things you would normally buy anyway (food, clothes, etc.), the level of risk is magnified since those items most often cannot be recouped in value. Now, we obviously have to purchase things like this, but using debt to obtain these things simply raises the level of risk that the loan represents.
The reality is that credit card debt is very easy to get into, but a lot harder to get out of. After all, nearly everything in our society leads us to believe that credit cards are a good idea. We have rewards and enticements thrown at us from every side to get us to use them, and there is no end to financial advisers endorsing them as a good financial tool when used correctly.
And a further reality is that it is very unlikely that anyone who ends up with credit card debt intentionally planned to get there. Instead, we tend to think that we are the exception to the rule, that we would never use one irresponsibly or get into trouble.
But the more exposure you have to the potential of debt, the higher the likelihood that you will end up in it. It doesn’t happen every time, but it sometimes only takes one time or one bad decision or one time when the best-case scenario doesn’t pan out. In this sense, using a credit card is kind of like playing Russian roulette, except we tend to believe that there aren’t actually any bullets in the gun.
B. TURNING ON THE FAN
In this light, the monthly float scenario can be fraught with peril because it assumes that the user is disciplined enough to only use the loaned amount to buy what should be bought, and also assumes that a best-case scenario is always the case and nothing will come up that will tap into the floated funds.
But what if something happens? Let’s say one has an emergency and the $4000 float money has to be used for an emergency of some sort. If there is no emergency fund in place (which obviates the rationale for the float in the first place), then the $4000 that is meant for the payoff must suddenly be used for that emergency, which means the floated $4000 will be rolled over to the next month.
With many credit cards, this will entail that the APR is activated, which means a 16% APR or higher might suddenly be applied to the balance. This will increase monthly payments, which either entails money must be redirected from some other place or- in what might begin a vicious cycle- another credit card might need to be used to make up the shortfall.
What may have seemed like a “free” monthly loan can quickly turn into something not so free.
Another insidious aspect of credit cards is that the 0% APR periods are often not interest free, but are rather interest deferred. That is, the interest quietly accrues underneath the 0% during the interest “free” period, but once that period ends, all the accrued interest is applied to the balance. Thus, if one’s best intentions don’t pan out and the introductory 0% period ends, suddenly one can be faced with lots of interest from the supposedly interest “free” period. And sometimes this occurs not just when the period ends, but even if you miss one single payment. In addition to late fees you may find the accrued interest up to that point applied to the current balance.
The tricky part is that while one might want to transfer the balance to another card with a 0% period before this occurs (or even after), there are still often 3% or higher transfer fees, which- depending on the balance- one may not have the current funds to cover, which may mean using another card to cover these fees, thus further perpetuating the cycle. And even if there is no balance transfer fee, one has merely kicked the can down the road a little further, which may actually mean even worse financial difficulties in the future.
When I got out of college, the only time I used a credit card was in an already risky scenario that I made more needlessly risky by means of using a credit card. I was contracted to create a video, but I needed a better computer to be able to work the project. I actually had the cash in hand to buy it, but since the purchase represented nearly half of the money I had, I decided to float the purchase on a credit card, with the plan to pay it off immediately after the project was finished, as the project’s revenue would roughly be equivalent to the computer’s cost.
In my mind the rationalization was easy- this computer was an investment, I knew I had the money coming in, and so why not let the credit card company take the risk, since I could basically be getting a free loan without having to risk my money?
Fortunately, the project went off without a hitch. The client was happy with the final product, I got paid and I had my computer, ready to take on more projects.
But a curious thing occurred in my mind as I got that check. This check represented roughly a third of my then current net worth, and so it seemed a shame to throw it away by paying off this debt. I calculated the monthly payments and realized I could easily cover them, and so why not keep that money and use it for something else?
I then went months making monthly payments on this debt, not really thinking about the costs it entailed or the risk it represented. I finally came to my senses and decided to just pay off the whole amount with my savings. Of course, I could have done this in the first place, but instead I actually ended up paying more for it by means of what I originally thought was a “free” loan than I would have if I had paid in cash.
In my situation I was fortunate that the end result of floating the purchase was probably only a few hundred dollars in interest payments. But in all of my calculations I was leaving out risk entirely and assuming that a best-case scenario couldn’t help but happen. Fortunately that mostly ended up being the case, but in retrospect I see how perilous this decision was:
What if- for whatever reason- the client hadn’t been able to pay?
What if- for whatever reason- I hadn’t been able to complete the project?
What if something else had come up that I needed to pay for?
We can obviously never predict the future, but borrowing against an uncertain future is always a perilous activity, and the peril is only magnified the more interaction one has with debt and the less margin one has between a debt and the ability to pay it off. It can often only take a couple times of the best-case scenario not panning out to land oneself in a financial mess.
C. MONEY ON THE TABLE
Credit cards can seem good way to smooth spending over time based on future earnings. After all, in the previous example, my notion was that it would be a shame to throw $3500 at a credit card debt when I could easily manage the payments and use the money for something else. But in this calculation I was misunderstanding opportunity cost and decoupling it from risk.
Opportunity cost is the cost of not receiving potential gain because of choosing a different alternative. In my case, I primitively thought I would be passing up potential gain by paying off my credit card balance; in my mind the relatively low cost of the payment would make sense financially relative to the availability of funds. After all, what if something came along that I needed this money for? Would it really make sense to give up the potential for greater gain just to pay of this (ostensibly) manageable debt?
At the time I didn’t fully appreciate that my calculation of opportunity cost was misguided on several levels. Firstly, I left out the amount of risk that this course of action represented. The debt had a fairly high APR (19% or so, I believe), but the monthly payment was just low enough to make me think it wasn’t that big of a deal. The short term lack of pain seemed to justify what in my mind was greater future potential for that money, and helped lull me into making payments I didn’t need to make.
Fortunately I snapped out of that quickly enough to mitigate much further damage, but in retrospect I have been able to see how carrying this plan out through its scheduled payoff date (that is, making all the seemingly small monthly payments) really represented leaving substantial amounts of money on the table in the form of opportunity costs.
I’ll use my situation as an example. The computer I purchased was around $3500 at around an avg. of a 19% APR. I don’t recall what the monthly payments were, but let’s assume the schedule was to pay it off in 60 months (5 years!) At that rate, my monthly payment would have been around $91 (so reasonable and easy!), with a final payoff balance of around $5450, which means almost $1950 extra in interest payments. (It will be noticed that the interest is more than half the purchase amount.)
Now let’s assume that instead of paying the monthly payment towards my credit card debt, I had used that payment to invest in my 401K or a Roth IRA. At $91 a month for 60 months at a 10% rate, that monthly payment would have grown to $6,813, which is a total spread of $12,263. This means that rather than having spent an additional $1950 on a computer by means of payments, I could have bought the computer outright and earned another $3300, which means the opportunity cost of buying by means of the credit card would have been over $5200.
Of course, the saddest part of this scenario is that I didn’t have or use this computer for the entirety of that 5 years, and even if I had I would not have been able to get anywhere close to recouping either the actual cost of the item, much less the opportunity cost.
Thus, if I had carried my credit card payments all the way through I would have still been paying for a computer I was no longer using!
Granted, this is a rather small example, but I think it illustrates well why credit cards are such a terrible way of purchasing anything. In my example, the computer of all things probably held its value pretty well over the potential 5 year term, and- to be sure- was an “investment” in the sense that it did allow me to make far more money with it than I spent on it.
However, even that calculation assumes the best-case scenario of an item always justifying its expense. In my case, this was right when I was getting started in design and video production, and so business was pretty lean for the first few years. While I was fortunate to make back the money I spent in the way that I did, these sorts of projects were few and far between for some time. Had I continued making payments on the computer over the term of the balance payoff, the return would have been that much less.
This is, of course, only one example of one purchase at one time, and thus the figures are fairly compressed.
But the difficulty with credit cards is that they make these sorts of purchases and payments easy to justify for many things over a long period of time, which only further exacerbates the opportunity costs associated with credit cards relative to the balance one carries.