Why Pay More When You Could Pay Less?

Why pay more when you could pay less? It doesn’t seem logical and yet many do this when taking on debt. Even when lower cost borrowing alternatives are available, often consumers prefer using high interest rate credit cards.

I just read a fascinating academic study that examines this seemingly irrational behavior. As is often the case, our “money mind” can lead us to choices that are not, strictly speaking, in our best financial interest.

Case in point: When we are contemplating a large purchase (perhaps a refrigerator) and do not have cash available to pay for it, we quite naturally say “charge it.” But in today’s interest rate environment, it would be quite easy for a person with good credit to get a low interest fixed personal loan for the amount necessary to pay for the refrigerator. So, why not?

• Ease. However streamlined new online lenders make their services, it cannot compete for ease with the credit card already in your wallet.

• Perception of indebtedness. This is where it gets interesting. What the research tells us is that when you take on a loan to pay for the refrigerator, you are actively saying to yourself that you are going into debt. When you pay with a credit card, not so much. Particularly if you are already carrying a balance, consumers do not attach the same “pain” to the credit card purchase. And just as we tend to spend more when we use a credit card rather than cash, the tendency seems to be to spend more when using a credit card rather than a fixed loan.

• Commitment. When you take on a personal loan, you have committed to paying back a fixed amount over a specific period of time. For someone who struggles with financial self-control, this can be a bit frightening. With a credit card, the commitment to pay back the money borrowed is more abstract and the timeline much more flexible.

What does this all amount to?

Stepping back, a key to financial health is to be in tune with your financial emotions, being “present” when making spending decisions. When contemplating a large purchase, ideally one would consider the cost and make a plan to save the amount needed over time. But when the purchase cannot wait, the take-home message from this research is to fully own the decision to borrow money. Explicitly recognize that you are taking on a debt, consider all of the options available and commit to a plan to pay it back.