Savers know there are certain marketing techniques to watch out for if they don’t want to end up parting with their cash unknowingly. Marketing is just as much an art as it is a science. It’s an understanding of how the subconscious mind works, what drives people, what their interests are and what makes them feel good. Okay, maybe I am getting too ahead of myself. I am not saying that humans are wandering around from store to store getting tricked into buying things, but our subconscious is powerful. While many of these opportunities seem risk free, traps are lurking behind them. Luckily, we do have our conscious mind to help us.
In this two-part blog post, I will discuss 7 money traps we are all susceptible to and how to deal with them.
Go beyond affordable payments:
Much of why feel we can afford to purchase items that slowly eat away at our bottom line and our ability to save is the push for ‘affordable payments’. This becomes even more detrimental if the item purchased depreciates in value like credit card purchases or a vehicle loan. If you stretch a loan term out long enough and make the interest rates bearable, then most people can ‘afford’ to finance it.
Conscious savers understand that to truly determine whether you can afford something or not, you must look at the true total cost of ownership. This includes the total principal and interest over the term of the loan. Here is how:
- When a product is advertised as a monthly payment, use this number and multiply it by the number of months in the term (you can find this information in fine print on the ad). This type of marketing is common for vehicle ads
- Subtract the number you got above by the cost to purchase the item outright (this information should also be disclosed, probably in fine print). The difference between these two numbers will give you the interest you will pay over the term of the loan.
- Determine if incurring this interest is worth it given what you get back in return? If it is, then at least you would have made the purchase with the full knowledge of what expenses you will incur. If not, try and find a cheaper alternative. Many times, just realizing the true total cost of owning something may change our minds altogether
Anchoring is such a powerful and persuasive way to trick the mind that it is used in negotiations, advertising and other areas of business. This mental trap tricks our minds into using the first price (or piece of information) we see or are quoted as an anchor for the decisions we will make. Knowing this information is powerful and it may stop you from overpaying on purchases. Here are some examples of anchoring:
- You are in the market for a house, a real estate agent shows you the first house and you know it is way above your price range. Even if you liked it, your budget couldn’t afford it. The first house becomes the anchor. Then they show you a second more modestly priced house, but still higher than what your budget will allow. However, you find it is a bargain compared to the first. It might even stretch your family’s finances once you account for all other expenses, but you feel it’s a steal and are so glad you got a good bargain.
- You walk into a clothing store and look at the price tag on a shirt that caught your attention. On the tag it has the regular price in big bold letters (the anchor). This price is crossed off with a big “X” and below its marked 50% off with the reduced price next to it. You think ‘what a bargain’ and proceed with the item to the cash register.
Don’t Become A Credit Victim – It’s a Psychological Trap
These are just two simple examples of anchoring and we have all been a victim to it. However, understanding how anchoring works and learning when it is being used can help avoid so many money traps. Some possible solutions for minimizing the effect of anchoring include:
- Give yourself a limit for how much you are willing to spend. Whether it is buying a house or a t-shirt and stick to the limit, no matter what. By setting a limit you are relying on your budget and not your emotions to drive your spending
- Understand when anchoring is being used and your emotional response towards it. Give yourself 72 hours before making a purchase. Try not to rationalize the expense on the spot by telling yourself things like, “I’ll figure out ways to make money in the coming months.”
- Do a lot of comparison shopping. Retail stores use anchoring to make us think we received a bargain. Research multiple stores online to see if the price reduction is really a deal before buying
The Limited Thinking of Saving, Instead of Investing, Money
It is important to make the distinction between saving and investing money. However, many people use these words interchangeably when they are different. To me, investing requires a risk/reward relationship whereas, with saving, everyone is guaranteed the same return.
A conscious saver is also a smart investor. With the exception of their fully funded emergency fund and a floating balance in their checking account, a conscious saver invests their money in financial and real estate property. They understand that in order to get ahead financially, their money needs to work harder than they do and they are willing to take a calculated risk in order to make it happen. The mentality with investing does not always have to be “think big, get rich.” Smart investors are willing to take a calculated risk in order to make things happen. They do adequate research before investing and know what they are invested in. They seek professional advice when they need it. Even conservative investors with a well-balanced diversified portfolio can get ahead of savers
Conscious savers also know that inflation is the silent killer of wealth and want to make sure that their investments are at a minimum meeting the cost of inflation (around 1.5%-2% per year). Anything less than this net rate of return would mean that the purchasing power of their money will go down each year. Put differently, it would take more money to buy the things you want when you retire, causing the retirement nest egg to get depleted quickly.
Teaser rates and reward points:
There are many personal finance bloggers that save money on trips, hotels and other items by signing up for credit cards, accumulating reward points and taking advantage of teaser rates. I don’t think credit cards with perks or introductory rates are bad in and of themselves but if handled incorrectly, they can drive our spending and negatively impact our finances. There are a number of reasons I don’t agree with chasing reward points and using promotional offerings to save money. Here are two:
Less than 3% of Americans pay off their credit card in full every month (Source):
That is an alarmingly low number so it makes you wonder how many people that use reward points as life hacks to save money, are not incurring interest charges in the process. Life is unpredictable and our financial priorities may shift day to day or week to week. Putting expenses on a credit card that can be paid for with cash can result in financial problems if our financial obligations or our wants grow faster than our income. Financial gurus (think, Dave Ramsey) often speak about cash as a healthy safe guard to our spending impulses, something that credit cards fail to do. This is why I am always apprehensive to promote accumulating reward points and using teaser rates as a way to save money. When the bill comes due or the new interest rate sets in, the statistics don’t support the majority of Americans to save money this way.
Open and closing credit impacts your credit score & affects your total debt service ratio (TDSR):
I have a few friends that have multiple credit cards which they opened to get promotional points or discounts. Once they received the savings and paid off the cards, they don’t use them anymore but still keep them active. One particular friend has 7 credit cards of which she only uses 1. This may seem like a harmless and effective way to save money, but limited thinking often prevents people from considering the impact this has on their total debt service ratio (TDSR). TDSR is a formula lenders use to determine your capacity to take on additional debt given the debt you currently have and your housing expenses.
Debt Service Ratio
In short, it takes your mortgage payments (or rent payments), plus your property taxes, condo fees (half the amount), heating expenses, plus all your other debt payments and divides this amount by your gross family income. The ‘other debt payments’ is what many people don’t consider. Lenders not only look at how much debt you have outstanding, but also how much credit you have available to you and what your minimum payments would be if you maxed out all your credit. Put it differently, most banks aren’t just interested in what debts you have when you apply for a loan, but what debt can you possibly find yourself in if you maxed out all our credit products. Because from a lenders perspective it’s not assurance enough that you have these credit cards but are not using them. So even though my friend has 7 credit cards totaling close to $80,000 of available credit and she only using 1 and hardly carries a balance, most lenders will assume the total $80,000 is available for her to use when she applies for another loan. This concept also holds true for lines of credit. This is why many lenders will require potential borrowers to close certain credit cards even if they don’t use it. The risk is too high. Having credit available to you, even if you haven’t used it for year’s increases your TDSR ratio and affects your ability to get other loans like a mortgage or car loan.
You may decide to close some of these cards to lower your service ratio since you are not using them anyway. That’s probably a good idea, but you need to keep in mind that opening and closing credit cards frequently lower your credit score. So even though your total debt service ratio will be lowered, your credit score may take a temporary hit. If you need to keep your credit score high to get approved for another loan, this may be the worst time to do this. Instead, get the credit you need and nothing more. Chasing rewards and promotional offerings can increase your total debt service ratio and negatively impact your credit score.
Buy now, pay later purchases
A common weekend money trap, the buy now, pay later scheme, or offers for a full year of no interest can be very tempting and difficult to pass up. My husband has actually taken advantage of a no-interest for one year promotional deal from a store credit card and used that card to buy a television, game console and stereo system at the store. I hated the process of paying this debt back because we had to stop our other financial goals and redirect our monies towards this credit card before the year was over. Not having the flexibility during that time to spend our money the way we wanted was annoying. Interest would reset at 29% and that was a number I was not comfortable with. To make matters worse, we were new graduates with little equity and no line of credit or cheaper form of credit to transfer the burden. However, this is the reality for many Americans and buy now and pay later promotions result in many consumers falling into a cycle of indebtedness.
I absolutely dislike everything about payday loans. From the repayment structure, to the way they relentlessly target certain demographics. It goes without saying, payday loans are probably one of the worst ways to fall into a never ending money trap and pit of indebtedness. Payday loans promote the convenience and ability to receive cash quickly. A proposition that is enticing for many, but the cost is too great. Annual interest rates at 300% to 400% ensures most American will remain in the debt cycle. Three-quarters of payday loans go to those who take out 11 or more loans annually. This explains why 80% of payday loans are taken out within two weeks of repayment of a previous payday loan.
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