Fri, May 02, 2008

Costly Plastic

Seldom does a month go by without some bank offering me a new credit card.  Alumni associations, my current banks, and banks who have somehow discovered that I have a small business all want to give me credit cards.  I always shred these applications, because tearing them up isn’t enough – apparently someone has done the experiment and shown that a credit card company will accept an application even after it’s been torn up and taped back together.  Still, I figure that if I’m getting this many applications, I’d be in big trouble if I couldn’t manage my cash flow well.

There’s nothing intrinsically wrong with using credit cards for purchases; I find that they make it really easy for me to keep track of how I spend my money.  For people who are able to pay the balances off each month, credit cards are a great convenience and can actually facilitate budgeting.

But there are at least two problems with credit cards.  First, for most of us (myself included) spending money with a credit card doesn’t really feel like spending money.  If I write a check for a thousand dollars, I can see right away that I’ve got less money, but I don’t get that feeling with a credit card purchase.  This phenomenon is well-understood by merchants; businesses accept credit cards because they expect people will spend more using a card.

The second problem is that most people don’t understand the long-term consequences of paying less than the full balance each month, and too many people get caught in the trap of just making the minimum required payment month after month.  At interest rates of 18% (or more) per month, you can spend a lot more money than you expect. 

Consider the following scenario:  Let’s say that there’s a stereo system that you’ve had your eye on for several weeks.  The list price is $1,000.  Today you notice that the system is on sale for 20% off, but you must buy it now to get it for $800.  Unfortunately, you don’t have $800 to spare in your checkbook, so you use plastic.  But hey, how could you afford not to take advantage of such a deal - you saved $200, after all.  The next month, the credit card statement comes, and you’ve managed not to use your card for anything else (remember, this is a hypothetical scenario!) but in the meantime your alternator dies and your mechanic only takes cash, so you still can’t pay the bill.  Fortunately, the bank that issues your card kindly offers to waive the minimum payment, so you don’t have to pay anything the first month.  The next month, your printer dies and you have to replace it.  Again, you just don’t have enough to make a dent in your bill, so you make the minimum payment of $20.

Let’s also assume that with one thing and another that happens over the subsequent months, your cash flow stays tight and you aren’t able to do more than make the monthly payment, though you do manage somehow to keep yourself from buying anything else with that credit card.  Assuming the card carries an 18% rate, how much did the stereo system actually cost you?

First of all, it will take you about 65 months (almost 5.5 years) to pay off the stereo this way.  You end up paying out approximately $1,280 for your $1,000 stereo.  Suddenly it doesn’t seem like such a great deal.  Another way to look at this is to calculate the present value of $20/month paid out over 65 months; with interest rates as low as they are, the answer is still somewhere around $1,200 (and still not exactly a deal, is it?).

I’d venture a guess that most people who carry credit card balances month by month have little or no idea what they’re actually spending on the things that they buy with credit cards.  This makes it a little easier to see how people can get into a debt spiral when credit cards are used to cover cash shortfalls.