Hidden Ways You Are Wasting Your Money With Credit Cards

If you were to think of how financial institutions make money on credit cards, you would probably say it is off the high interest rates charged to customers. It turns out though, that a significant part of their profits also come from fees they place on merchants who accept credit cards for goods and services.

The stores don’t pass these fees — which can be close to 2% per transaction — on to us because they too want us to use credit cards. But the million dollar question is how do the stores benefit from this? If they only accepted cash, it would give them an easy 2% saving. It doesn’t make basic economic sense. Usually, that is a sign that some behavioral economic principle, that most of us don’t understand but fall prey to, is at play.

It turns out that people will buy more when they use a credit card compared to using plain cash. And we don’t just buy a little more, we do it to an embarrassing extent–which many studies have shown, including one done at the Sloan School of Management at MIT [1, 2]. Another study showed that people also tend to underestimate or even forget the amount they spend when a credit card is involved [3].

This works out nicely for the stores and explains why they willingly pay the credit card companies this 2% cut.

Credit cards lack the physicality of cash. When you pay with cash, you need to count it. Then you have to watch your money disappear into the retailer’s cash register. But paying with a card is a quick mental activity with little immediate consequence. Our unconscious mind, which makes many of the buying decisions anyway, does a poor job at deducting money from our mental accounts when no physical cash is involved — and so we end up spending more.

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Now, what about the cashback and airline miles many credit cards hand out? Again, this hurts us in the end as the influence principle of reciprocity benefits the credit card companies. The little that they give us back is cleverly marketed as a free gift or check to us. Now, our subconscious obligation to repay this favor compels us to use our cards even more. Not to mention, our conscious desire for getting additional miles or cash back.

It’s the classical misdirection to distract us from the main robbery.

Return 1 to 2 dollars for every 100 skimmed and make the victims still feel good. Distracted by the rewards program, we lose sight of how much we are wasting on unnecessary purchases.

Few of us realize that paying with a credit card influences us to buy more than we really need. Some might claim they don’t fall for this. In reality, their denial is the ultimate proof that they are the biggest and most oblivious suckers.

How to protect against this

If you want to save your money, use cash instead. You will find yourself buying and spending less over time.

However, if you are too addicted to the convenience of a credit card, you could try making a point of removing around 10-20% of the items in your cart (in-store or online) at checkout. This also counteracts other persuasive tactics that retailers use to get us to buy more than we intend.

What this can teach us in work and life

Look for ways in which we are influenced subconsciously. These are hard to find but if you develop an understanding of how this process works, it will be easier to spot.

In the business world, interactions that have a physical presence are more productive and influential. If you want to persuade someone on an important topic or idea, you need to do it in person. Email, phone, or Skype may not cut it. Take the trouble to meet in person even if it means a business trip.

It’s a lot easier to misunderstand a sales pitch or proposal in an email or phone call when non-verbal cues are absent. Plus, people may find it harder to say no when you are physically in their presence.

References

1. Feinberg, R. “Credit Cards as Spending Facilitating Stimuli: A Conditioning Interpretation” Journal of Consumer Research, 1986, 13 (3), 348-356.
2. Prelec, D.; Simester, D. “Always Leave Home Without It: A Further Investigation of the Credit-Card Effect on Willingness to Pay” Marketing Letters, 2001, 12 (1), 5-12.
3. Soman, D. “Effects of Payment Mechanism on Spending Behavior: The Illusion of Liquidity” Working Paper, College of Business and Administration, University of Colorado, Boulder, CO.

Keywords

Personal Finance, Behavioral Economics, Overspending, Credit Cards, Persuasion, Mental Accounting, Spending Behavior

If you want to get deeper insights and advice on these topics, these books will help you.

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