Tuesday, December 20, 2011

Which Part of "Bad Idea" Don't You Get?

Which part of 'bad idea' don't you get?

A reader writes:
" Have you heard about this gas discount card? If you sign up for it, you get 5% back on gas purchases!  There is another card, where you get 3% cash back at supermarkets, 2% at gas stations, and 1% on all other purchases!"
I have written about this before, and this sort of thinking is what I call faux financial acumen.  And if you want to get ahead in life, stop thinking this way.

Why?  Well the people at the bank and the credit card companies are not idiots.   In fact, they are a lot smarter than you are.  Just get over this fact and stop assuming you are going to pull a fast one on some major financial institution.

Then get out your calculator and your brain and think.  Credit card companies charge 2-5% to the retailer on every purchase you make.  How much they charge depends on the transaction, the type of card used, and a number of factors.  But this is one way they make their money.

Now, think about this a second.  Here, the credit card companies are generously offering to pay you about that same amount.  How, pray tell, will they ever stay in business? 

If you pay off the balance every month, you pay no interest, of course.  And if they pay you 2-5% on a purchases, how are they going to even break even?  After all, in addition to the staggering costs of running a credit card business, they also have to account for all that bad debt and fraud, right?

They are not running a charity.  Benevolent Billionaires are not tossing their money away so you can have discounted gas.  Rather, they know how you behave - and they are playing you like a cheap violin.

The second way they make their money - really the primary way - is through the interest they charge their customers.  And they make a staggering amount of money this way.  And these "rewards" cards have staggering interest rates.  The gas card mentioned above has a 13.99% rate and the other card has a rate that can be from 17-22%.

Are these high rates?  You betcha.  These are rates that, until the early 1980's, only loan sharks could charge.  They are so-high-you-never-pay-it-off rates.  And if you get into trouble with one of these cards, well, you probably are on the road to bankruptcy.

As I noted before, most Americans have a credit card crises at least once in their lives.  Some go from crises to crises - refinancing their home to pay off debt, and then running up more debt.  Some never pay off the debt, but end up owning until they are dead.

How does this happen?  How does a snowball start out as a single flake and then roll down the hill until it ends up as a giant ball of snow big enough to crush a house - or a car?  It takes time, but it builds up, slowly.

And since we, as humans, have trouble visualizing long-term effects (I guesstimate that human economic memory is about 18 months, tops) we fail to see how these schemes play out over time.

Harry and Harriet Homeowner get the 5% back gas card.  They are being smart consumers and saving money!  After all, gas is expensive and getting money back on gas is good!

This brings us to our first point.   Gas is used as "bait" in a lot of bad financial transactions. The local grocery store uses it - offering 50 cents off a gallon of gas (up to 20 gallons, or $10) if you spend hundreds at the local store.  Are you getting ahead?  Not really, just a $10 discount after you've spent a lot of money.   But since people grouse about the price of gas, it is a common form of "bait" used by the powers-that-be and also by the outright con artists.

Whenever someone presents you with a financial transaction that somehow throws in discounts on gas or free gas, your "Spidey sense" should be tingling, as they are pushing a hot button designed to appeal to you emotionally.  Why gas?  Why not a discount on, say, your utility bill?  Or your phone bill?  Again, because gas is a hot-button issue that people have strong emotions about.  And we all know how thinking emotionally about money is a bad idea!

Remember what I said about them playing you like a cheap violin?  Using "gas" is bait is perfect, since most Americans salivate like Pavlov's dogs at the thought of "cheap gas".  People will drive 10 miles out of their way to get a penny off on gas - oblivious to the fact they spent more driving there.  And yet, they will pay the "asking price" on a brand new car.  Gas is perfect emotional bait - beware of it!

So, anyway, they use the gas card to buy gas.  Harry and Harriet are typical Americans and drive 15,000 miles a year, each, in their Hondas (far too much driving, in my book, but that is another issue).  They average 25 miles per gallon.  Using our calculator, we realize that they buy 1200 gallons of fuel a year, which at $3 a gallon is $3600.  The 5% discount, per year, comes to $180.

Gee, $180!  That's a lot of money!  But that assumes they pay off the balance every month and never, ever, carry a balance.

Because, if they do, the savings evaporate like spilled gasoline.  Even a small $1500 revolving balance would run $187.84 a year in interest, at the staggering 13.99% rates the card company charges (for the other card, with rates as high as 22% things get exponentially worse - such is the way interest rates work).  This would wipe out any "savings" in short order.

And what is more, the credit card company is counting on this happening.  Why?  Because they have computers - and the computers tell them that most people end up carrying a balance.  In fact, most people carry huge balances - thousands of dollars or more.  "I can never seem to pay off my credit cards" is the most common financial complaint.

But when surveyed about credit card debt, people lie to the survey taker - and themselves.  And some real financial idiots take this to mean that the computers at the credit card companies are wrong and that the people answering the surveys are right - because people don't lie about their finances.  Nothing could be further from the truth.   We all lie to ourselves about our credit card balances and our excess body weight.  I'm not that fat!

Even if you pay off a balance after 2-3 months, you still pay a lot of interest.  And that can eat up any savings in terms of cash back.

So Harry and Harriet Homeowner go along their merry way, convinced they are being smart and astute and saving money.  One day, at Home Depot, Harry doesn't have any cash, so he buys a load of lumber on his cash-back gas card.  Of course, there is no 5% cash-back on a load of lumber.  At the end of the month, he realizes that he doesn't have enough cash on hand to pay off the balance, so he lets part of it "roll over" to the next month.

Meanwhile, Harriet is charging hobby supplies from Michaels on her card, and the balance increases.  They go on vacation and charge gas and hotel rooms.   Every month, Harry and Harriet pay off most of the balance, but since there is always some balance on the card, it "revolves" and they pay interest on a huge part of the monthly average balance.

Harry realizes he is paying too much interest, and disgusted, he pays off the entire balance with one check - eating up most of his paycheck for the month.  But now, being broke, Harry and Harriet have to use the credit card to make purchases for gas, groceries and other supplies.  They even use it to pay utility bills!  So while they pay off the balance that one month, the next month, it is even higher and cannot be paid off.

Like a washing machine with a sleeping bag in it, their balance wobbles back and forth like this, each time wobbling more and more, until finally, the machine walks away from the wall, pulls out its power cord, and tears the water lines out of the wall, flooding the basement.  (How's that for a tortured metaphor?).

This is how credit card debt happens.  And it ain't pretty.  Just a little bit at a time, over a long period of time, and one day you wake up with $5,000 to $15,000 in credit card debt.  Ouch.

Too late, Harry and Harriet realize that while they saved $180 on gas, they are now paying $350 a year in interest payments.

They throw pennies at us, hoping we spend dollars.

Well, actually, Harry and Harriet never actually realize this, as they never sat down with a calculator and figured out how much they were saving on gas and how much they are paying in interest.   Like most Americans, they just look at the bills every month and see whether they are paid or not.  Overall long-term effects are never examined very closely.  Or if they are, they are so frightening that they quickly put it out of their mind.

So how do you avoid credit card traps?  Don't use credit cards at all, if you can help it - pay cash, use debit cards, write a check.  If you need a credit card, for business, for example, get a card with a low interest rate and a low credit limit.  Keep the credit limit low, and don't let them raise it!  You can call them and have them lock it at a low rate.  There is no reason to have a card with a limit of more than $5000.  And for some people, perhaps only $1000.

If you find yourself reaching your limit, think about why, and where the money is going.  Stop spending and take action to pay off the balance.

And if you have a low interest rate, well, you can actually have a stab at paying it off - and not paying staggering interest fees.

Credit cards are a trap - a real trap.  And the only way to avoid getting caught in a trap is to not step in it in the first place!   It is like being a compulsive gambler or alcoholic.  You can't just "gamble a little" or just "have one little drink" - you have to go cold turkey.

The only difference between gambling, alcoholism and credit card debt is that the majority of us are not alcoholics or compulsive gamblers.  But most of us are chronic spenders and most of us get into credit card debt.  And there is no 12-step program for credit card debt, that I am aware of.

Don't tell me about how nice the bait is, in the trap.  It is still a trap.  A deadly one!