Oh if I had a dollar for every one of those "Best Credit Card of 2016" articles I have seen. Or rather if I had 25 cents for every click it got or 5% of all sign up fees that were paid from the article I wrote that was sponsored by said credit card companies to market their products... but of course that never happens. Reading these articles and their accompanying comments is like going to a redneck Walmart at 2AM. The people watching is real! I am truly in awe of the marketing geniuses these companies are and their extremely sophisticated use of psychology. I thought I would go ahead and take a shot at my own article. I am sure it will make some people very angry.
The Power Of Positive
Anyone who has had any contact with the outside world over the past month has surly heard of the recent Powerball frenzy. The record breaking 1.6 billion dollar jackpot had people from far and wide coming out of the woodworks to get in on the 1 in 292,000,000 chance of winning this sum of money. One lady even created a GoFundMe page after her inevitable loss to regain her savings along with an extra 100k. Ironically enough, this probably had a better chance of working than winning the powerball. The page had already received $800 in donations when it was shut down. For most people who played the Powerball it was simply something to do. A way to be a part of the conversation or join in with your coworkers on an office pool for which everyone pretty much knows they aren't going to win, but it makes for good lunch conversation. For others, there was a serious hope and prayer that they would win. But one question still remains: what makes people go so crazy over such absurdly small odds?
The answer falls back to some cognitive biases like I talked about in Humans Are Hardwired To Suck At Investing. Two of the main biases that are exploited with the lottery are Availability Bias and Present Bias. Availability bias is the tendency to judge probabilities on the basis of how easily examples come to mind. Present bias is the tendency to value immediate rewards over long term ones. You can easily remember a time you have heard of a lottery winner and can definitely easily see yourself winning. However, it is very hard for us to truly wrap our head around how small the odds of winning are. Winning the lottery is instant wealth over what saving money can do over the long term. Another example of this is the fairly recent Ebola freakout. How many people do you know that didn't die from Ebola? Chances are pretty much everyone you have ever met in your entire life. Yet people were going crazy over a astronomically few cases in the U.S. Why? Because the prevailing thought was that getting Ebola is assured death at a quick rate. It was so widely publicized that we all saw people that had it so we misjudged the probabilities to an irrational point.
So what does this have to do with credit cards?
Exploiting Our Biases
Credit cards, much like the lottery, are in the business of exploiting our biases. They use a number of tactics that are aimed at taking advantage of every bias they can to the point that we rarely notice. No tactic is stronger than the truly infamous credit card rewards.
In 1986, Discover was the first card to issue "cash back rewards". Today rewards credit cards can be found with virtually every company. It is truly engrained in the American culture so much so that the fact that I am writing this article will no doubt make a lot of people very angry. People love their rewards and there is an abundance of articles on the internet to support that. If you are getting angry then I ask you to take a look at this article: www.neurosciencemarketing.com/blog/articles/cognitive-biases-cro. It is from a website called Neuromarketing. Here is a quote talking about the cognitive biases:
When you grasp just a few of these psychological nuggets, the advantage you possess is almost unfair.
These marketers know these biases well and use them in every way they can. I think credit card companies are some of the best at it. Check out this one specifically on rewards programs.
The rewards programs on credit cards are taking advantage of some of the same types biases as the lottery. First and foremost, they take advantage of what is called the Framing Effect. This is the idea that people will behave differently depending on how a situation is presented. In a study by Nobel Prize winning scientist Daniel Kahneman and Amos Tversky in 1981, the scientists explored how people respond to the same situation whether it was framed in a positive light or a negative light. They told participants that there was a deadly disease that affected a total of 600 people and they were to choose between two treatments. In the positive framing example, Treatment A was said to be predicted to save 200 lives whereas Treatment B was predicted to have a 33% chance of saving everyone and a 66% chance of saving no one. In this frame, a full 72% of participants chose Treatment A. In the negative framing example Treatment A was said that they predicted 400 people would die whereas Treatment B had a 33% chance no one would die and a 66% chance everyone would die. In this case only 22% of participants chose Treatment A. Upon further inspection you can see that the outcome of Treatment A is the same in both cases. 200 people are saved and 400 people die. So why is the difference between the results so drastic? What they found is that when a situation is framed in a positive light people tend to avoid risk. When they say Treatment A will save 200 people then people will go for the 200 for sure saved rather than risk no one being saved even though the expected outcome is pretty much the same (1/3 x 600 = 200). Conversely when a situation is framed in a negative light people tend to seek risk. Rather than for sure killing 400 people they would rather take the chance for saving everyone.
In a different example, possibly a more applicable one, PhD students were sent an email to register for a paid seminar. In one case there was a penalty on the registration fee if they registered late. In the other case there was a discount for registering early. 93% of students registered early when the penalty fee was introduced whereas only 67% registered when the discount was introduced even when the amounts were exactly the same.
So what does this have to do with credit card rewards? Well let's talk about what these "rewards" actually are. If you spend $1000 on a 3% cash back card then you get $30 back. So that means you have effectively obtained $1000 worth of goods for $970. Instead of saying you get 3% cash back the credit card companies could also say you get a 3% discount. Mathematically, this would be the same thing. Yet why is it cash back? That is where the framing effect comes in. The "reward" is framed in a positive light. Who doesn't love a reward, right? It makes us feel good to have spent money and then receive that money back in our bank accounts. Over the month, it can add up so at the end of the month you get your reward and really feel like you got those credit card companies. If instead you simply got a discount people would not be going so crazy. This is not an accident, but rather a well researched and thought out tactic.
Another bias that is being exploited, although much harder to do, is the Bandwagon Effect. This is exactly what is sounds like. If everyone is doing it then it must be okay. Having a credit card is like eating breakfast or brushing your teeth. We don't need to stop and think about it too much because everyone is doing it. Do a quick google search and you will find a million articles about how to maximize points. I want to point you towards two articles posted on the same website, Invetopedia, which does have some really great information. The first is your typical "Best Credit Cards of 2016" article. It includes link to go apply to the credit cards. They are no doubt getting either a commission on clicks or a commission when people sign up through their site. This is called Affiliate Marketing. In that article they are talking about "credit cards being a tool" and things like that. The next is an article on store branded credit cards. It brings up the point that the credit card rewards programs tends to lead people to overspend effectively canceling out any "rewards" they get. Overspend by 6% and you canceled out your 5% reward. Yet why do they not mention this in the other article on regular credit cards? They are both credit cards and both offer cash back rewards and therefore the tendency to overspend is the same or even more for regular credit cards because you can use them anywhere. Well if you are getting paid to advertise credit cards (which they definitely are) then you don't want to mention that. That would be bad "framing".
The Bottom Line With Credit Cards
The idea behind rewards programs are simple. Offer cash back rewards and people will tend to spend more; it is just the way they work. If you spend more, they make more in transaction fees. And if they are super lucky you will miss a payment and hold a balance and they can start smacking you with 15 to 20% interest. But I know what you are thinking. That is not you; you are responsible and would never overspend due to rewards. That is other people (by the way, there is a cognitive bias for this as well called illusory superiority bias).
Let me just give you one last reason to reconsider:
The entire finance series is about getting you in a position to become financially free. This can be achieved regardless of income. The fundamentals are pretty simple: protect against emergencies, save money by spending only on things you value, eliminate debt of all kinds, and use free cash flow to make wise investments for your furture. Can you tell me where credit cards fit into that? No where. Credit cards and their accompying rewards incentivize spending. They cause people to spend the majority of their time trying to maximize their rewards instead of optimizing their spending and finding ways to lower their fixed expenses. They promote debt as a tool. They push people to focus on building credit rather than building a net worth. And worst of all, they promote a dependency on the banking industry when it comes to making a purchase. You need a car? Come to our bank to get a loan. Need some furniture? No worry, we have interest free financing for 700 years. Need a house? We can most certainly give you a mortgage for a house far more than you can afford because it is an investment. All of these things make it harder to become financially free. You can go your whole life without using a credit card and do what I described above and build an amazing amount of wealth. That is why I have never had and never plan to have a credit card. Also, I never recommend anyone to get one.
The Darker Sides of The Credit Industry
Unfortunately, there is a darker side to credit cards. Almost everyone I have talked to about credit cards feels they are the exception. They use them as a tool and are in turn reaping the benefits from the credit card companies without paying them a dime. If you ignore the opportunity costs of what you would be doing if rewards weren't incentivizing you to spend then that might seem to be true. You spend money, they pay you money, you don't pay them interest. But one question has to be bothering you. Would the credit card companies do something that would cause them to continually lose money? Of course not. These are large institutions that make billions of dollars per year. So what is funding these programs? It is a combination of two things. First, there are transaction costs that are levied on the merchants and businesses that use their processing systems. These costs typically vary depending on the type of card you use. For credit cards it can average 3 to 4% of purchase price plus a flat fee of around 30 to 40 cents per transaction. Although, not all of this going directly to the credit card companies. So the rewards are partially funded by these fees. But these companies don't want to just break even, they want to make a lot of money. So where does the profit comes from?
The real bang for the credit card company's buck is in interest and fees. You know, the fine print stuff that no one really reads. Because hey you are responsible, right? Just like no crack addict sets out to be addicted to crack, no one in credit card debt set out to be heavily in debt. It starts off as usual. Use it a little here and a little there. Get some rewards and feeling pretty great. Then all of the sudden something crazy sneaks up on them! Like ... Christmas! Who knew they moved it this year from August to December?! I have no doubt that many people are still suffering from their Christmas hangover on their credit card bill. Then one month they get a little behind. Car breaks down or dishwasher goes out. So they pull out the credit card just to make ends meet since they are probably in the nearly 30% of Americans that have no savings whatsoever. Little by little things rack up and soon they find themselves not being able to make ends meet. They pick up the slack with, you guessed it, more credit card debt. Its not surprising that 34% of Americans in 2014 were in credit card debt. The credit card companies need these people to survive. If they don't have people in revolving credit card debt then they don't survive. It is as simple as that. So think about this. In a way your cash back rewards are coming partially from the increase in the price of goods you bought since the merchants simply pass that transaction fee onto you as well as a middle to low income family that is struggling in a mountain of credit card debt. Sure the families got themselves into it. They overspent, they took the debt, and they need to clean it up. You didn't force them to do that and the credit card companies didn't either. But the companies sure as hell were willing to lend them money at 15 to 20% interest knowing the family can't afford it. They will for sure break federal laws attempting to collect on that debt. They will surely give a college student with no credit history, no job, and no income a shiny new line of credit knowing good and well that they will hold a balance and pay them interest. Just like the drug cartels should be partially responsible for the tragedy that drug addiction can bring on people's lives, the credit card companies cannot completely absolve themselves from blame. Lending to subprime borrowers is part of their business model. Paying federal fines for breaking the law is part of their business model. Putting middle and low income families in debt that they can never get out from under from is also part of their business model.
I know the vast majority of you will not stop using your rewards credit card simply because I wrote this article. That is okay. But here is an alternative to consider just for shits and giggles.
Here is my best credit card recommendation for 2016: Chop up your credit cards and burn them. Forget they even exist. Use your debit card. Use a budgeting app like EveryDollar or Personal Capital to begin tracking and planning your spending every month. Look for expenses that you don't gain much value from. Put yourself on your own cash back plan. Set up an automatic transfer of 10% of your income to go to savings or paying down debt. I promise you that you will end up with more money and just the same amount of satisfaction at the end of the year then if you just used your 3% discount card (that is itching itself to charge you 15% in interest). If people spent just half the time and energy they spend on trying to find the greatest credit card there is or trying to get that free flight and spent it looking for ways to save and making sure they are making sound investments then we wouldn't have such a problem.
I'll leave it with this. There a plenty of ways to build wealth out there. I can guarantee you no person who has built a substantial amount of wealth is going to say "man the best way to build wealth is to get you a Chase Sapphire card and start earning 3% cash back on restaurants and dildos". That is just not going to move the needle that much. I promise. Please leave me a hateful comment below or feel free to send me hate mail at firstname.lastname@example.org. :)