Student Investment Expert’s Tip of the Month – April

A while back (from Oct. 2001), two professors at the Massachusetts Institute of Technology in Cambridge conducted an experiment. The two, Drazen Preiec and Duncan Simester, held an auction for tickets to a Boston Celtics basketball game. Half of the bidders—chosen randomly—were told that the winner would have to pay for the tickets in cash (with a grace period to come up with the money). The other half were told they could use a credit card. The bids of the credit card people were twice as high as those of the cash people. ’Chargers’ were willing to spend more.

Credit cards can be tempting to use because they allow one to easily postpone paying for purchases. At a minimum, credit card users are given 3 weeks to pay for purchases interest free and are given the option to only make a minimum payment at a fraction of the total amount charged. Through these means, credit cards can be damaging in two ways. First, as described in the anecdote above, we tend to pay more for things we buy with credit cards, and second, we don’t always have the means to pay for our purchases putting us into debt with very high interest rates that can be as high as 20-30%.

As an alternative, many people use debit cards to make purchases so that money is debited automatically at the time of purchase. There are many drawbacks to debit cards as well. First, unlike credit cards, debit cards do not help to establish one’s credit score. When one uses a credit card responsibly and pays off the balance every month, it gets reported to credit score agencies so that banks know you are a credit-worthy borrower when you apply for loans like for a car or a home in the future. Second, using debit cards doesn’t solve the phenomenon described in the above experiment of a willingness to spend more for the same item. Third, if you overdraft your checking account, banks can charge fees as high as $30.

Everyone is different. The key to responsible finance and savings is to know yourself. If you cannot manage a credit card successfully, a better alternative may be to use cash. Studies have shown that the physical act of seeing cash leave your wallet creates a psychological mechanism in your brain to spend less, and you won’t put yourself in danger of finance charges for late payments with credit cards or overdraft fees with debit cards. If you have trouble managing a credit card, try using cash to pay for things.

~ Monte Malhotra, Student Investment Expert, Campus Calm

Click here to learn about The ABC’s of Creating Credit Calm, a 66-minute audio coaching CD with Maria Pascucci and Monte Malhotra.

This entry was posted in Archive. Bookmark the permalink.

Leave a Reply