I have written a lot of articles on how easier payment methods are robbing you blind. It has very little to do with you, and much more with the ‘type of money’ you’re using. It’s what they are designed to do.
Easier money is supposed to be easier to spent. That’s its entire premise. Now one ‘easy’ solution for dealing with this is to simply not engage. Here this means to avoid all easier methods (mobile, contactless, credit, BNPL etc.) and to simply use cash. But as the world becomes increasingly anti-cash, this becomes harder and harder. Also, this completely knocks out the option of online shopping; for some the only way to get groceries and other essentials in. And have you ever tried paying down a mortgage cash?
So a mass return to cash is not likely to occur, so we’re sort of stuck with the ‘modern money’ that we’ve got. In today’s article I want to focus on what that means for credit cards. Why credit? Because that’s one of the most complex payment methods out there. Behaviourally speaking.
Let’s start at the very beginning. Because there are behavioural mindfucks going on not just when using a card, but also when selecting one. Credit cards cost money; you have to pay for the privilege to be in debt. But somehow people are completely insensitive to the cost of a card.
Most credit cards have two cost components: a fixed and a variable cost. The fixed is the annual fee: the privilege for owning the card. The variable component is either the interest on outstanding debt, or the fee associated with the outstanding debt. Cards come in either form, the ‘fee form’ being remarkably similar to BNPL products… Now in addition to the cost of the card, there are its potential benefits, which is what people are very sensitive to: are they collecting awards points? Are there cashback offers, travel insurance etc.? A last key part of the credit card is its limit; how much debt you can take on at once. Although behaviourally science’s main argument is that people focus more on losses than on gains, I can promise you that’s not the case here.
So how would a ‘rational’ or at least a behaviourally informed person select a card? Well, their motivation for having the card would be to consumption-smooth: only spending money they know is coming in soon, but need to spend now. Here arises an immediate issue: how do you know this money is coming in and why don’t you have it saved? And this is where for me, the ‘rationale’ for having a credit card already crumbles. You don’t really need one from a behavioural standpoint. But let’s continue the argument. You know how much you need to complement your income with, on average, and as a result you pick a credit card with a limit that fits that amount. You’ve calculated you only need about $2,400 a month, maximum. And are going to repay this monthly (assuming a stable wage). The limit you can select closest to your estimate is $3,000, so you choose that card limit. As you are sure you’re going to repay the balance in full, every month, you decide to aim for the card with the cheapest annual fee which is somehow not the card with the lowest interest rate. However, when you don’t revolve debt, interest doesn’t matter (issue is, most people do revolve…). Now these cheaper cards don’t tend to be ‘awards’ cards; they don’t give additional benefits. But you, as a behaviourally informed consumer know that you don’t actually use many of these awards to begin with. Your friend has already saved up lots of award points but keeps forgetting about them and even the airmiles you would get from using the card for ~$2,400 per month don’t seem to be worth the additional cost in annual fee of several hundred dollars and the even higher interest rate. That’s called a cost-benefit analysis.
Yes, credit card selection is a complicated process which requires quite a bit of calculation and introspection; you need to be honest with yourself and really know your own spending and (re)payment behaviour.
Is that how most people go about selecting a credit card? Of course not. And it’s not their fault either.
Most people aren’t aware of their over-focus on the benefits and almost blatant ignoring of the costs. They’re also not aware of the impact a limit can have. Nor do most people actually know what they want the card for; they haven’t done the consumption smoothing calculation at all. Given this lack of knowledge, how does the average human being select a card?
If you don’t know how much you need, rather than want, in terms of a credit limit, most people then tend to guess (and severely overestimate) or, they don’t take the limit into account at all and get distracted by the ‘nice to haves’ the card offers. Which leads to the benefits: if someone asks you whether you’d like to have travel insurance, the answer is most likely: ‘sure, why not?’ However, if you were to be asked whether you need travel insurance on your credit card the answer is very different. The same goes for the usefulness of these cashbacks and the awards point associated with the more expensive cards. Would you like them? Sure. Do you need them? No. Do you know what to do with them? Errrr… And there’s the problem. Given that we’re now all just collecting ‘nice to haves’ we are moving ourselves into the domain of more and more expensive credit cards. But people aren’t sensitive to their cost at all. And you know which people are the most sensitive to awards and the least sensitive to cost? The people who can’t afford the card to begin with…
Do you know how to calculate an interest rate? I mean, you specifically might, as you’re reading this and seem to have an interest in money management, but most people don’t. Most people don’t understand interest, let alone compound interest. As a result they don’t really understand how credit card debt can grow and, well, spiral. For the sake of simplicity, most people are better off on a credit card with a free structure: you pay a fee for having revolving debt, not an interest rate. These types of structures are a lot easier to understand, and are the reason BNPL products have become popular. Interest rate cards are too tricky to understand.
Another reason why it’s best to stay away from high limits and interest rates is the optimism bias. Bet you didn’t see that one coming. The higher the limit of a credit card the more people spend on it, regardless of whether they actually have to. The more you spend, the less likely you are to be able to repay the amount in full, therefore increasing the chance of revolving the debt (carrying it over to the next month). So now you have to pay. Not just the repayment of the debt, but also the interest (or fee) cost. Fees tend to be relatively low – you can calculate their ‘rate’. A $10 fee on a $2,000 debt is 0.5%. The average interest rate on a credit card is about 20% (per year), which is ~1.67% per month, which would cost you $33.33 in interest for that month alone. Of course, if the debt you’re revolving is much lower, or much higher, these calculations change. But that doesn’t matter too much if you never did the calculations to begin with.
When I said that credit cards were a complex product, I meant it. The complexity lies in them praying on your ignorance: you not knowing your own spending and (re)payment behaviour and the behavioural pitfalls you might be suffering. If you really do want something as complex as a credit card, you need to put in the work beforehand.
And so far we’ve only discussed credit card selection. We still have to talk through the complexities of credit usage and repayments. Which we will do in the next article, I promise.
Now what are you supposed to do if you’ve read this article and are like ‘shit, I’m using the wrong type of card, I’ve been had!’ Don’t worry, there’s two options: get another (cheaper) credit card or close the card down. In case of the latter, repay the debt in full asap, and just close the card down. Don’t just cut it up and forget about it because that means you might still be charged an annual fee. If you can’t repay the debt quickly because the card is too expensive, or you still want to have a credit card, just a different one, switch to a cheaper card. This can be done through an online or phone application and tends to be quite straight forward. Don’t let yourself get seduced by great offers in the meantime. Stick to your guns! They’re all distractions trying to get more money out of you!