Why People Underrate Psychology When Using Credit Cards

I was a having a spirited discussion with a personal finance blogger the other day regarding credit cards and the “rewards”/ cash back bonuses one can earn by using them. I was in agreement with the blogger, if used correctly credit cards can indeed be used to accelerate your business enterprise and give you extra money on items that are deemed “recurring” in nature. The problem with that last sentence is we are overrating human discipline and its complexities.

Case in point, research suggests that credit cards prompt overspending, with people often overspending for the same product that they could have paid cash for. This so called “credit card premium” helps reduce the pain of parting with our money and may reinforce bad spending habits. Being aware of the biasing effects of credit is more important than what mere numbers would suggest. This post aims to share the mindset I use when thinking about particular spending categories.

Business Spending

If you are a business owner, credit  is usually treated differently because purchases are driven for enterprise building purposes. If you are spending for client acquisition or the purchase has a potential return on investment component (building a website for instance) credit is being used to create value. Taking into account the tax considerations, business related budgeting is very different than most personal budgets.

Example: A trip to San Diego for business is not the same as a trip to San Diego to go yachting with your spouse or significant other.

Structuring your Personal Expenses

Structuring your personal expenses into variable and fixed costs is a worthwhile exercise. A fixed cost is defined  as an expense that does not change as a function of the activity within a relative period, while a variable expense is an expense that fluctuates according to your spending. Once this exercise is completed  I try to put most of my fixed expenses, that are recurring and necessary in nature on a credit card. A big assumption with fixed costs is not only the recurring and predictable nature of the expense, but that you are setting up fixed costs that are reasonable to your budgetary constraints.  

Examples of good candidates would be your utilities, and any insurance based payments you may have.

Why Variable Expenses on a Credit Card Can Be Hazardous

This is the bucket where most people destroy themselves. Credit card expenditures on eating out, drinking or shopping are the usual culprits. For most people I would avoid using your credit card in these instances all together and I would instead use a debit card to make these purchases.

Setting up Proper Barriers

Creating a system for your money is very important and most people do not have one. One thing you can do is automate your payroll into a separate bank account just for your eating out money for example. With doing this the debit card has a set dollar amount, which if exceeded will be declined when you try to make excessive purchases.

 

Want more on creating an accountable money system? Follow me @themoneynudge on Twitter & feel free to signup for my email list for programs and much more!

Don't Get Fleeced By a Lease

A new car is a vanity decision. Once you know that analyzing your options become a lot easier. 

A new car is a vanity decision. Once you know that analyzing your options become a lot easier. 

Materialism is one of those things that most of us don't want to think about because it has negative connotations. Let’s be serious here, who actually goes up to their friends and says they are a materialistic person. Ummm no one that I know! Whether it's a gadget, a brand you like wearing, we all have fallen prey to “stuff.” What is weird is we are told time and again that objects don't make us any happier, yet our brains keep playing the same trick on us to buy anyway. Let’s journey inside the human mind when making a decision about a car lease….

A Lease is a Vanity Driven Decision In Most Instances

The biggest mistake people make when leasing a car is not just that it is a bad financial decision, it is the fact they don’t admit that it is mainly driven by vanity. Leases for some are a way to buy a new car that they really “want” but can’t reasonably afford.  The first step to financial understanding is to admit that you are making a purchase out of weakness.

What to Do

One way to anchor your emotions is to run the numbers and understand what you are getting yourself into. Let’s look at an example of buying versus leasing over a six year period shall we? 

Tale of the Tape

Looking at a promotion on Edmunds.com I was able to find a 2017 Acura ILX for $199 a month, 36 month term, with 36k in miles. The catch on the deal is $4,199 due at signing. The total cost for three years comes to $11,363. Let’s assume you found a similar lease again for another three years. Your total cost comes to $22,726, or $3,788 a year for six years.

The same vehicle had an average sales price of $28,038 according to car pricing service TrueCar.com. If you put the same $4,199 down and financed the car for 60 months (5 years) at 4.0 percent, you would calculate a monthly payment of $439. Assuming a depreciation decline curve (30% of MSRP) after six years the residual value of the car comes out to $9,042.

How Did It Finish

The lease appears more attractive but the overriding factor is I own the asset at the end of the six year. After factoring in the sale of the vehicle, financing comes out ahead by $1,227 dollars.

The Takeaway

Although it appears financing and leasing are a wash in this example, remember  the lease was given every possible advantage. Based on pure numbers it is very hard to find scenarios where leasing wins. The main scenario does not factor in a better deal on financing or a terrible lease negotiation (hint, hint most people don’t get the optimal lease terms I described here). In other simulations, financing the car came out $6,000-$7,000 ahead on average over the same six year period.

One Man’s Viewpoint

I don’t believe in financing or leasing new cars. I actually would prefer to buy when the depreciation (the largest cost of a vehicle) is negligible. That usually means looking at cars that are 5-7 years old. Although you worry about breaks and repairs the numbers are compensating me for the risk I am taking on. Why save $6-7k when you can save $10k or more over the life of a car?

Just like buying a home, time horizon is possibly the most important factor

In a prior post I stated that duration is really the key determinant in home buying, and financing a car is no different. If you refuse to hold the car for the duration of the loan then the lease does become a bit more attractive.

Aaron, I am going to lease a new car anyway…

Sometimes in life, the best advice falls on deaf ears. If this is the case, you can read my article on considerations to consider when negotiating a lease. My thought is if you are going to make a bad decision you can at least make an educated one.

Car Purchase Series: This is one post in a series pertaining to the car buying experience. Stay Tuned!

Disclaimer: The article is not a recommendation of any financial products, it is merely for educational purposes.

More: Aaron Connell is a writer and Principal of One Brick Planning & Consulting, a Gen Y focused financial services practice.  Have a question for Aaron? Email him at pfinconsulting@gmail.com

 

Why First Time Home Buyers Should Be Wary of 30 year Fixed Rate Mortgage Group Think.

“If everyone is thinking alike, then somebody isn't thinking.”

― George S. Patton Jr.

When discussing mortgages there are a lot of preconceived notions and misinformation out there. In today’s low interest rate environment we are so focused on where rates are going we fail to ask the home buyer the most important qualifying question: “How long do you plan on staying in the home?” The whole point of personal finance is that it is indeed “personal” in nature, with one buyer’s situation being very different from another. Although a 30 year fixed rate mortgage may be the best for most people, it may be inappropriate for others.  Unfortunately we are seeing too many 30 year fixed rate mortgages being sold to first time home buyers that may not need them. The result is wasted money due to interest.

An example I ran across at a social gathering is a case in point of this phenomenon. My friend, a single guy, had just bought a home. He discussed at length that it was a starter home and his time horizon was more based on fixing it and upgrading within the next few years. After hearing this story, I asked how he financed his purchase, and to my surprise he was in a 30 year fixed rate mortgage. Ouch!

The Reality

The reality for first time home buyers and younger adults is that they just don’t stay in their homes or condos very long. It is later home purchases in one’s life cycle that tend to have a longer length of stay as children enter the picture and people stay rooted in their communities in their later years. According to the National Association of REALTORS® and its 2015 Home Buyer and Seller Generational Trends Report, the typical under-40 home buyer expects to live in their home for a period of 10 years. In some urban markets the holding period is even less.

Tale of the Tape

After doing some digging  on some industry averages, I looked at the 7-year, and 10-year ARM as well as the 30-year fixed rate loan to provide some illustrative comparisons. The assumptions I made was a $400k mortgage, a duration of 10 years, the max interest rate increase for both ARM products, and that any interest savings in the intro period were reinvested to pay down more principal.  The results for the 30 year mortgage after the ten year period was ~$135k in interest paid. The 10- year ARM was ~$122k in interest with the 7- year ARM breaking even with the 30 year around the 9 and a quarter year mark, assuming an interest rate doomsday scenario. The 10 year  ARM broke even with the 30 year under the same criterion around the 11 and three quarter year mark.  Assuming the a lower end of the holding period (7 years) the ARMs obviously fair better. 30 year interest checking in at 98k in interest, 10 year at 89k, and the 7 at 80k respectively.

Conclusion

When looking at mortgages, the duration element is the largest factor to consider. The point of the piece is to raise awareness that the 30 year mortgage is by no means a slam dunk, no product ever is. That is why we must analyze our personal situation prudently and challenge basic consensus if it doesn’t meet our goals and objectives.  If you're buying a house and planning on staying 12 years or less you may want to change how you are thinking when you shop for a mortgage.

 

Home Purchases Series: This is one post in a series pertaining to the home buying experience. Stay Tuned!

Disclaimer: The article is not a recommendation of any financial products, it is merely for educational purposes.

More: Aaron Connell is a writer and Principal of One Brick Planning & Consulting, a Gen Y focused financial services practice.  Have a question for Aaron? Email him at aaron@onebrickplanning.com.