“Forewarned is forearmed” – English Proverb
Debt is big business. Everywhere you look these days, it seems that there are an ever-increasing number of ways to have whatever your heart desires, long before you’ve earned the money to pay for it. Whether you’re looking for a car, a couch or a cup of coffee, if you have access to enough credit, you can have that item right now, regardless of how much money is actually in your bank account.
It wasn’t always that way; 30 years ago, credit was much harder to obtain and debt was considered shameful. Nowadays though, it’s exactly the opposite. Debt is not only accepted but also encouraged, and not just by the banks and credit card companies. The business of extending credit to customers has become very profitable for businesses – mostly because companies make more money when their customers are late with payments or only pay the minimum amount rather than the full balance.
As consumers, we need to be aware of how debt works, which debt traps are out there, and what we need to do to avoid being sucked into them.
Here are two common debt traps and some suggestions for how to avoid them:
Buy Now. Pay Later.
The Trap: Buy Now, Pay Later offers usually come in one of two forms. Either a loan with no payments required for a certain amount of time (6 months, 12 months, 18 months), or a credit card with no interest on the purchase and no payments due for a certain period of time. Regardless of how the financing is set up, the intention is the same; to appeal to a customer’s impulses by removing all the usual barriers to purchase. The retailer’s hope is that the customer’s instinct to buy will drown out that little voice asking the questions, “do I really need this?” and, “can I afford to pay for it?”
How do companies make money by extending these amazing offers to customers? It’s simple. Retailers know that the percentage of people who will actually pay off their balance in full before the due date is very small. Once you miss the payment date, the retailer can back-date the interest charges to the day you bought the “stuff”. When you consider that many store cards or financing deals charge a 29.9% interest rate, it’s not hard to see how the cost of the $5000 furniture set you bought 18 months ago can increase overnight to $7500 if you don’t pay off the balance in full, on time. It also becomes clear how those backdated (and ongoing) interest charges can make a lot of money for the lenders.
Avoid the trap by:
- Don’t get lured into making an impulsive decision; take at least 24-48 hours to think about taking on any kind of “buy now, pay later” financing deal. Figure out a payment plan that’s manageable and allows you to get the debt paid off early. If you can’t afford it, wait. Those “one time” deals are never the one offs that the marketing ads suggest – it’s just a sales strategy.
- Make the payments on time: Your loan is only interest-free as long as it’s paid off, in full, on time. No matter how much of the loan you’ve paid; unless the balance is 100% paid off, you’re still going to be charged ALL of the interest owing on the full purchase price not just the outstanding loan balance. Whether you set up automatic payments from your bank account or go into the store each payday, make sure you get the whole balance paid off well before the due date. If you can’t manage the payments, don’t make the purchase.
Pre-Approved Credit Cards
The Trap: This was the offer that first sucked me into dealing with credit. I had avoided applying for credit cards, partly because as a student I wasn’t sure if I’d be approved and partly because I knew how much I liked to shop and I was worried I might not be able to exercise enough self-control to keep my balance in check. Then one day, a few weeks before Christmas, a letter arrived from my bank informing me I’d been pre-approved for a credit card. All I had to do was sign the enclosed slip and the card would be mine. I happily signed on the dotted line and waited for my card to arrive. At 20 years old, I had no understanding of how credit cards worked or how the interest was calculated. I knew I could pay everything off or just the minimum but those minimum payments were so small that, in essence, I thought the bank had just handed me $1000. In reality, it had handed me a shiny new shovel and invited me to dig a hole. That was the first step of a 15 year slide into debt that it has taken a lot of hard work to get out of.
Avoid the trap by: ignoring the offers. If you’re thinking about applying for a credit card, shop the market to see what’s available, choose a card that suits your needs (moneysense.ca does a great credit card review each year) and make sure you have enough money set aside to pay off your balance in full each month. If you’re already in debt, don’t be tempted to take on any more – it will only make your situation worse. Now, when those pre-approval letters arrive in the mail, I shred them. I don’t need any more credit and knowing that the only reason the lender is making the offer in the first place is because they’re hoping to attract customers who will carry a balance and make them money just makes it easier to ignore.
As I said at the beginning, debt is big business and one of the reasons it’s so profitable is because retailers have figured out so many ways to allow us to have whatever our heart desires at the instant we desire it. Research has shown that for gamblers, the anticipation of a win actually fires up more pleasure centres in the brain than actually winning. It’s the same for consumers; the thought of buying something gets us more fired up than actually making the purchase. Retailers know that if we’re allowed time to “cool off” and think about buying something, the chances of us making the purchase decrease. Instant credit allows them to offer us a way to buy things we don’t really need, with money we don’t have and it makes them a lot of money in the process.
I’m not saying that credit is always a bad thing; just that if you’re going to play the game, make sure you understand all the rules, because these days, it’s far too easy to get burned.