The Difference Between Financing Your Spending and Buying on Credit
You could say that these two things are the same and technically, they are.
However, when I think of borrowing money for a long period of time and paying interest on it I think of it as financing your spending.
When I buy something on my credit card and pay it off before the end of the month I consider it buying on credit.
Does that make sense? No? Ok, well that’s how I say it so tough. Anyway, this is how I clearly define the difference in my head. I am more than happy to buy something on credit that I know I can pay off quickly and avoid interest payments.
A Quick Note About the Potential Risks and Rewards of Buying on Credit
This method involves a lot of willpower, but as long as you are sticking to your overall budget then it really doesn’t complicate things all that much. You see, when I buy something on my credit card it comes straight out of my budget for the month as if I had spent the money on my debit card or used cash. This way there is still a realness about the spending. I can see the dollars leaving my budgeted accounts and it doesn’t feel like a real credit transaction. This is an extremely important part of the process. A lot of times people get into trouble simply because they have a tendency not to keep track of purchases that they make on their credit cards and they make a mental note to “tally it up at the end of the day/week/month”. The problem with this strategy is that the spending doesn’t get tallied up until you’ve already overspent. If you overspend on your credit card then you are in catch-up mode the next month only this time you have some interest added to the mix if you weren’t able to cover the payment. This is not using a credit card smartly, it’s financing your spending.
The benefits to buying on credit all the time are huge if you consider the perks that many credit cards offer these days. I remember thinking when I was younger that those reward points sure do sound nice, but what’s the point if you are just paying interest every month? Back then I didn’t realize that the correct way to handle cards was to actually pay them off every month (mental slap to younger self). The reality is that as long as you are paying your card off each month, rewards points/miles/etc really can be “free money” for you and your family.
Let’s just do a quick example with my current card:
I currently get 1% cash back on everything I spend plus 5% on a few rotating categories each year (gas, amazon, etc). Now, this is by no means the best card out there, but let’s see what I can get after a year of just normal spending. I typically average about $1700 in spending each month on my credit card for “normal spending” i.e. bills, groceries, etc. This is money that I would be spending no matter what. This equates to $17 each month in cash back on my rewards card. However, the rotating categories sometimes include grocery stores, gas, or other things that I’m normally spending money on so this will give me a bump each month that will vary a little bit. Let’s just say that I typically get 5% back on about a fifth of my normal purchases. This will add up to $30 each month in rewards money! But wait, there’s more! As a promotional offer Discover also doubles any money that you receive in rewards at the end of your first year. That means I’m really getting more like $60 each month (for the first year, but still!) That’s $720 “free dollars” the first year!
Assuming you can handle the responsibility, rewards cards are an awesome deal.
Interest Rates and the True Cost of Purchase
Now, if you aren’t able to stay strong when using credit cards or you already have debt on the books that you’re struggling with then you will be hit with interest each month that you are carrying this debt. We all know that paying interest is bad, but it’s easy to just look at the minimum payment due each month and not really see the impact that the interest is having on what you’re really paying when you’re financing your spending. Let’s take a simple example like using a credit card to buy new furniture ($2000) without the ability to pay it off in the first month. Using a quick interest calculator will show what happens on a normal card with 20% interest rate if you only pay the minimum.
Minimum payment: $53.33
Time to pay off: 186 months (15.5 years)
Interest paid: $2723.59
Hopefully nobody would actually take this long to pay off their furniture, but in reality I’m sure this happens all the time. And people wonder why they are poor! You are paying MORE THAN THE COST OF THE ITEMS in interest payments. This is ludicrous. This is a very normal scenario that could happen to anyone. They probably wouldn’t even realize that they are paying this much in interest. I promise that the credit card company is not going to highlight your total interest and time to pay off in big bold letters to warn you. Like it or not, but they are a business and they make their money by charging interest on purchases.
So, do you really need that furniture now?
How Financing Primes Your Brain to Spend More
Let’s not forget the mental aspects of financing something like furniture. It all starts because you want something that you can’t currently afford. At a certain point you’ve convinced yourself that you need this item and you must get it as soon as possible. So, you whip out the credit card. Maybe you even take advantage of some promotional pricing where you don’t pay any interest for 6 months. Great! You’re still spending over $2000 in interest if you stick with minimum payments after the offer runs out. But that’s all in the future, what about now?
Once you finance this purchase you may have a little guilt after the initial buzz wears off. You’re sitting on your nice, new sofa and have your feet propped up on your nice, big ottoman and you’re feeling good until the first bill comes. You open it up and you see: minimum payment $53.33. That’s it??? Awesome!
“I didn’t realize it would be so cheap” you say to yourself, mentally patting yourself on the back.
That’s what minimum payments and introductory offers are meant for: putting you at ease and making you feel like the purchase is not making a huge impact. After all, you are just paying a little out of pocket each month and you can certainly afford that!
See what happened? You made it, financing your spending didn’t kill you. You have all the things you wanted, but you don’t really notice any harmful effects from it. This is a mental recipe for disaster because you start to feel comfortable with the purchase and then comfortable with the thought of additional purchases. As long as your monthly income can support those minimum payments, you think, you can afford all kinds of stuff!
While it’s true that there may not be any huge impact right away, just think of the potential for these small amounts to start adding up. Think about all of the additional spending that you would be doing for the same purchase. This type of spending is inefficient and toxic to the average person.
Just to put things in perspective, that $2723.59 would end up being $59168.69 in 40 years when you retired if you had stuck it in your IRA instead of paying extra interest on that sofa.
How comfortable are you now?
Check out the next article in the series to how: Once You’re In Debt It’s Hard to Get Out!