This guest post is by Tim Chen the founder and CEO of NerdWallet.com, a website that helps consumers to compare low apr credit card offers. Tim also educates consumers about credit cards and personal finance at the Christian Science Monitor, Forbes Moneybuilder Blog, and the Huffington Post. If you would like to write you own guest post click here.
Have you ever wondered why most of us have a propensity to “buy now and pay later?” After all, somewhere in the deep recesses of our minds, we know that we can’t really afford to charge that shopping trip to Paris; not when the economy is going bust and they’re handing out pink slips at work. But we do it anyway, thinking that may, just maybe, things will be different in the future.
It’s kind of like going to the gym, isn’t it? When you signed up for that membership, you might have known that there was no way you were going to go there every day for the next two years and spend an hour sweating. But you did it anyway, didn’t you?
Welcome to the world of hyperbolic discounting – the foundation on which credit card companies, and yes, the originators of gym memberships, have built their businesses. What is it exactly? To break it down into its most basic form, it’s the idea that humans (and some animals) will always take what they want now rather than wait for a better payoff in the future.
How does this tie into credit card spending?
In a 1994 study made famous by Green et al, it was shown that people who were given the choice of $50 that day, or $100 a year from then overwhelmingly chose the $50. Why? Because our brains are hardwired to want satisfaction in the immediate future, and we mentally discount the latter consequences. This falls into the realm of what’s called “behavioral economics” because it strays from economists’ standard view that we are all robots trying to rationally maximize our personal wealth.
Credit card interest and fees are perfect examples. Most people understand intuitively that if they spend $1,000 on their credit card, and then make the minimum money payments on that balance, it will take 106 months to pay off at 15% interest. And they know in the back of their minds that they will end paying so much more than they initially bargained ($1,700 according to the debt calculator at bankrate.com). But hyperbolic discounting is like short-term tunnel vision. It kicks in and all they can see is the immediate payoff – like that European vacation they can’t afford.
This is also why people sign up for rewards credit cards that charge higher interest rates and exorbitant annual fees. All they see upfront is the promise of 1% cash back, and they will end up spending more than usual, with their eyes on that monthly bonus. But what they conveniently ignore is the mounting interest bill and the $100 fee at year end that more than wipe out any rewards they earned over the last 12 months.
Don’t be that guy (or gal)
When you’re tempted to let your right brain prevail while ogling that prized possession, remember this: your credit card company knows you better than you do. They realize that you are likely to discount the consequences of your desire, in exchange for immediate gratification. It’s how they can afford to fly around in private jets and dine out in exclusive restaurants, while you chip away at mountains of debt.
In fact, your inclination to use hyperbolic discounting will very likely be the most spirited topic of conversation at that very dinner. In other words, they’re playing you. Are you going to let them win?