The psychology of credit cards and what makes a good credit card
In this article, we discuss about credit cards, their pros and cons, how they exploit the psychology of the brain and what makes an ideal or good credit card.
What are credit cards
A credit card is a kind of financial instrument that gives us access to short term credit. We can use the credit cards to buy goods and services as we wish within the spending limit of our credit card, and at the end of the month we pay the credit card bill, either fully or the minimum payment required. Credit cards are a very convenient way to do shopping or other business transactions. They also typically comes with lots of perks such as good discounts and lounge access or golf court access.
In India, many people have multiple credit cards to take advantage of the different features of each, such as Amazon pay credit card for purchases on amazon, one credit card for lounge access benefits, one rupay credit card for UPI transactions, one with low exchange comissions for foreign travel, etc.
Pros and cons of credit cards
The main advantages of using credit cards include the following:
- Convenience of usage, of having short term loans that one can pay back at the end of the month. So if one is running short of cash and needs urgently to purchase something before their next paycheck, this can be a lifesaver. Usually, one gets a maximum of 45 days (1 month to generate the credit card bill + 2 weeks to pay the monthly bill) of interest free usage after making the purchase before they have to start paying back. One can utilize to the maximum by making a bigger purchase as close to the beginning of the month as possible, in what is known technically as front loading.
- Convenience of paying back the credit card balance in easy monthly installments or EMIs.
- Low minimum payments required every month. This can be good for small businesses or people who do not have a fixed salary coming in every month, but might get a good sales month where lots of money comes in and they can repay the pending bill in full. However, this does lead to a lot of accumulated interest due to high interest rates and is a major cause of people getting into debt.
- Feature of getting a cash advance, where the user can withdraw cash from an ATM using their credit card. However, this feature typically comes with high one time fees or higher interest rates than other types of credit card spending.
- Dispensing with the need to carry bundles of cash notes or coins.
- Security features, such as ability to cancel the card whenever lost or stolen.
- Purchase protection, including protection from fraudulent transactions, within the credit card rules. The user is not liable for fraud transactions on their credit cards if reported promptly.
- Opportunity to build or improve one’s credit score by paying the credit card bills in time.
- Perks that come with the credit cards such as discounts on transactions, airport lounge access, free cinema tickets, buy one get one free offers, reward points etc. Some of these perks can lead to substantial savings, depending on the usage of the person. For example, if one is a regular Amazon user, then an Amazon Pay ICICI Credit Card can give 5% cashback on all amazon.in purchases.
- Using credit cards for investment: While it is not recommended to use credit cards for investment, in India it is allowed in a few cases including: investing in gold (such as physical or digital gold via MMTC PAMP) and investing in Tier-1 of the National Pension Scheme or NPS.
However, as mentioned, there are also a few disadvantages that include the following:
- Credit cards encourage us to spend more, and often beyond our means. Research has shown that people using credit cards spend almost double on things what they would normally spend (with cash or debit cards).
- Credit cards encourage us to be impulsive about spending. We are more likely to buy things when having a credit cards that we would otherwise not buy, or would be carefully thinking before buying, if we were paying by debit cards or just cash.
- Credit cards typically have very high interest rates. In India, the typical interest rate can be around 35%-50% per annum. This is the interest we need to pay on our outstanding credit card bill, if not repaid fully every month. AZdded to that is the penalty and the negative effect on credit score if we do not make the minimum payment on the credit card balance every month.
- People can easily get into a cycle of debt by using credit cards, where they pay only the minimum required payments every month and the debt keeps accumulating because of the high interest rates.
Psychology of credit cards
fMRI studies have shown that using credit cards activate the pleasure centres and reward processing areas of the brain such as the striatum, mainly because of the pleasure of purchasing new things.
The abstract of the related Nature paper by MIT Sloan researchers reads as follows:
In an fMRI shopping task, participants purchased items tailored to their interests, either by using a personal credit card or their own cash. Credit card purchases were associated with strong activation in the striatum, which coincided with onset of the credit card cue and was not related to product price. In contrast, reward network activation weakly predicted cash purchases, and only among relatively cheaper items.
Our brain has inbuilt mechanisms that feel pain when spending money, so if we pay using cash, those regions would be activated. This mechanism normally acts to control our spending and temper the pleasure of buying things. However, when using credit cards to buy something, since we do not have to spend cash immediately, it does not register the pain in our brains the same way. Thus, credit cards detach the pleasure of buying things from the pain of spending money.
What makes a good credit card?
Most people, when asked the question of what is the best credit card, would choose the one that has the best features, that gives the best airport lounge access, the best discounts on money spent online or offline, the best cashbacks, etc. And indeed, there is no doubt that the perks of good credit cards such as discounts are indeed desirable.
However, given the cons of credit cards such as too much debt and high interest rates, a good credit card should have at least some of the following features (aside from, or instead of the regular perks):
- A low interest rate for the credit card loans, preferably along with a low or zero annual fee. Typical credit card interest rates in india are 3% per month, so rates of 1% or 1.5% would be good. Same goes for credit cards in other countries such as USA: find the typical interest rates in your country, find out the interest rate for your credit card and then decide if it is good.
- A clear breakdown of spending per month or per week in different categories, so that users can have a clear idea where their money is going.
- Allowing the users to set category wise limits on their credit cards usage, such as monthly limits on travel, foreign spending, electronics, restaurant spending, groceries etc.
- Sending warning messages to the user via SMS or the credit card apps, when their credit card spending in any category is approaching the limits. Also a reminder message when the payment deadline for the month is close.
- Some mechanism to encourage early repayments of the credit card bill, such as displaying how much is the amount of credit card interest the user would have to pay if they do not repay by a certain date.
- Credit card discounts or perks that incentivise healthy living and healthy financial practices.
Conclusion
In this article we have briefly discussed the pros and cons of credit cards, how they affect our brains and encourage us to spend more, and what makes a good credit card.
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