Borrowing Time

Behavioral economics provides a rich vein of topics for anyone who writes about personal finance. Today I am thinking about an academic study I read a few years ago that found that quite often consumers will borrow at a high credit card interest rate even when they have a lower interest rate alternative available to them. This is especially relevant right now, as this recent article about the spread between credit card and personal loan rates describes.

Let’s imagine that you are going to buy a new appliance, a water heater for example. This is a full-on need, not a want, and you do not have the savings to support this purchase. The obvious advantage of a credit card in this circumstance is ease of use. Even if you are aware of which financial institutions can offer a low rate unsecured loan, after your cold shower you may not be too much in the mood to complete a loan application and wait for the proceeds to arrive.

But what if the need is not so urgent? What the study I mentioned earlier found was that consumers have a different view of credit card debt than loan debt. Just think about the difference in language: “loan debt” versus “credit card balance.” Which one sounds worse? The researchers found that borrowers do not attach the same negative emotional connotations to credit card debt as they do to a bank loan. This is amplified when the consumer already has a credit card balance, and the new water heater is simply adding on to existing debt.

There was an even more interesting finding. When you borrow money via a credit card, yes, there is a required minimum payment. But really, the commitment you have made to pay back what you borrowed is pretty flexible. You can tell yourself that you will pay it off in 12 months, but no one will come after you if you don’t. (In fact, the credit card company will much prefer that you take just as long as you need, no worries.) On the other hand, a personal loan comes with a fixed repayment term. That can be pretty intimidating, especially if this isn’t your only debt or your income is irregular.

I believe that this last point — commitment — is at play in a related situation but in a quite different way. It is not at all unusual for me to encounter people who simultaneously have ample cash savings and a credit card balance (sometimes high interest, sometimes not). Yes, you could withdraw $1000 from the bank and head over to the big box store with ten Benjamins in hand, but then you remember how long it took you to build up that beautiful savings account. And now you want me to use it? Do you know how many brown bag lunches and no-appetizer restaurant dinners that bank balance represents?

The problem is that unlike the credit card issuer, once you leave the ATM, no one is going to complain even a whiff if you don’t pay it back to your savings account. Our cash-poor appliance shopper embraced the credit card’s relative lack of commitment; our cash-rich shopper seeks out that tenuous thread of obligation. The lack of a duty to pay back your savings account can be frightening.

So what to do? Start by seriously analyzing if borrowing is actually necessary. Is it really the case that a large withdrawal from your savings will leave you in a financially vulnerable position? Or does it just hurt to make that spend? Develop a specific repayment plan to pay yourself back and track your progress in doing so.

If indeed you do need to borrow to make a necessary purchase, embrace the debt. Seriously. If you have a decent credit score, pat yourself on the back for being in a position that allows you to shop around and seek out an affordable borrowing option. That’s a luxury that many people do not have. But before you sign off on the debt (whether it is a credit card receipt or a loan document), have a plan in place, in writing, as to how you will pay it back. (This could just be a memo on your phone.) And how you will build savings to avoid debt in the future.

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