Friday, December 22, 2006

The Nature of Credit and the Nature of Man

Since i began work about half a year ago, the nature of credit (cards) and the possible financial perils that accompany owning a card/cards is something that I have been thinking about. Now lest anyone thinks that I am about to go on a tirade against credit cards, let me just make clear that I am not. As the extremely astute and articulate Mr Wang has pointed out (come on ST, don't disappoint me) here , here and here , there are ways to "beat" the system and come up on tops (or at least, not fall into the credit leach that credit card companies are capable of turning into).

A more subtle danger of using credit cards though, is the possibility of interest-free installments. Now I am not a financial guru (I'm sure our well-acclaimed financial journalists can provide some valuable insight - in fact they do, sometimes - though rarely), so my subsequent arguments will essentially take a common-sensical/logical approach rather than an empirical, show-me-the-proof train-of-thought.

Now, as the term suggests, "interest-free installments" basically means you repay what you owe without paying additional charges on interest (assuming you pay your bills punctually). Perfectly ok, one may think - but herein lies the twist, and danger. And it has nothing to do with financial models or statistics, but the nature and psychology of human beings.

Why do I say so?

Firstly, the nature of man (this is not a sexist language) is such that we are generally folks who do not like to take on - or at least minimize - the responsibility for our actions. Before you go "huh", let me explain further.

This tendency and desire to "pay less" is a natural one - and one that credit card companies exploit to their maximum advantage. Say if Mr Tan decides to purchase a lap top that costs $1,500; in addition, he wants to buy a $3,000 sofa set as well as a 42-inch LCD TV that costs about $3,500...if full payment is being made upfront, he would immediately be $8,000 poorer, and assuming he's a salaried employer (earning about $3,000 a month), most likely he would think twice before forking out for all three items.

But with interest free payments, he is able to spread out the cost over, say, 24 months. Each month, all he has to do is to repay about $333 in installments. The cost (or responsibility) of paying for what one owns is diminished temporarily (at least at the moment of purchase); this creates a false sense of reduced liability. To state in simpler terms: If one does not feel the pinch (and pain), one does not know that he is in trouble. By spreading out the "pain" over 24 - or 48 months - it makes the consumer think that he can get away with what he wants at a lowered cost. In fact, what it only does, is to tempt the consumer to purchase more (than what he originally needs, or is able to afford) without considering the costs - and common sense - of doing so.

Secondly, human nature is such that the utility obtained from material consumptions are only temporal ones. So if today, Mr Ali commits $3,000 to a brand new state-of-the-art home theatre system and decides to pay by installments (because he earns only $1,000 a month and is unable to afford the product directly); most likely, 6 months down the road, his interest in his theatre system will wane (according to the Law of Diminishing Marginal Returns), unfortunately, his commitment to a 24-month repayment scheme does not. So the amount of utility he obtains from having the theatre system go into the negative - in short, the burden of owning a set exceeds the utility he gains from the set. Now, you know why SIngaporean car owners change a set of wheels once every five years...

These two reasons are why the concept of interest-free payments - while increasingly popular - are starting to become baits to financial destruction. To be honest, I absolutely dislike living on credit (because it is an indirect form of covetness), although sometimes this is impossible to avoid. In fact, I am living on credit now (due to my wedding preparations), the difference being - I am willing to pay for what I think is valuable (my relationship with my wife-to-be), and this value exceeds that of what money can quantify.

Some pointers to consider:

1. Remember - there is no such thing in this world as a free lunch. Whatever you owe, you'll have to pay back (if not now, then later).

2. The bank always wins.

3. If you are feeling impulsive about buying something, it is a sure sign that you probably don't need that thing. Unless its value can be qualified in other non-quantifiable ways (i.e. a professional photographer paying 10 grand for a camera knows what he is getting out of the camera), don't be stupid and jump into the bandwagon as well. A confession: One of the worst purchases I have ever made was paying $450 for a Palmtop (few years back) for appointment-jotting. Afterawhile, I decided that remembering my appointments in my head was far by the easier thing to do. Now the palmtop is an expensive paperweight.

In all fairness, using credit cards and interest-free payments are perfectly ok. The only issue is that most folks do not seem to understand the psychological logic of how these mechanisms work. So the next time you are tempted to plonk down $5,000 for a product (esp with a beaming salesgirl saying "oh, its interest-free", better think twice before doing so.


Anonymous Anonymous said...

Sensible piece of advice, Ben. I suppose buying things on credit is fine, if one is sensible enough to know WHEN to stop. And that sense of satisfaction when I first lay my hands on the iPOD or the PS3 .... hmmmmm... you can't describe it unless you experience it. Poor people like me can only do so with credit of course! LOL.

But I like your thinking... Is that the reason why you're holding back on getting a new car? Or new wife first izzit? ROTFL.

12:01 AM  
Anonymous hermanchauw said...

Interesting. Only buy if you can afford the full price of the product.

7:57 AM  

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