It’s bad enough that many of us don’t know the annual percentage rate (APR) our credit cards charge.
But even when we do know the rate, we are not good at understanding how much the interest will cost.
A new study from a University of Maryland economist showed just how bad people are at estimating their financing costs when they buy something on revolving credit – and how expensive that mistake can be.
“It’s difficult for them to incorporate and understand what the real cost of the goods is going to be,” said Mary Zaki, economist at the University of Maryland.
In Zaki’s study, 1,477 people were given a choice of buying an Amazon gift card by saving from a given income stream, or by using credit. People who chose credit were asked to calculate the number of months it would take to pay off the purchase at a given interest rate.
People using revolving credit “overwhelmingly miscalculate the required months needed to pay off the credit plan,” concluded her paper, “Interest Rates: Prices Hidden in Plain Sight.”
What’s worse, few people pulled back on credit even when the interest rate jumped from 18 to 42 percent. Although their out-of-pocket cost more than doubled, credit users kept right on charging.
See related: Guide to rising credit card interest rates
Cost of credit in dollars versus APRs
The key point of the study was how differently people behaved when they were told the cost of credit in dollar terms instead of interest rates.
- For example, at 18 percent, a $50 credit purchase would cost them $4.58 in interest over a given repayment period.
- When interest rates jumped to 42 percent, the financing cost was $12.63.
Given that information, 19 percent of the people seeing credit costs in dollars decided not to finance the purchase at the higher rate, although they were willing to finance at 18 percent.
What about the people who only saw the interest rate went up? About 2 percent of them decided the higher rate was too costly. Few decided to save instead, or forgo the purchase.
The implication is, “If you just see interest rates, you make purchases you otherwise wouldn’t,” Zaki said.
More than 1 in 4 card accounts carry a balance
With credit cards, this risk of overspending is widespread. According to the American Bankers Association, 44 percent of card accounts carry a balance over from one month to another, racking up interest charges.
Zaki emphasized that she’s not anti-interest rates. Knowing the APR is a critical tool for comparing different forms of financing. It is also the most important thing to know when deciding which credit card balance to pay off first. The Truth in Lending Act requires credit cards to state their APR as a bedrock form of price disclosure.
But even when armed with accurate interest rates, people aren’t good at estimating their interest costs. Her finding helps explain one of the factors behind overspending on credit cards.
What to do about it?
A better way to estimate the cost of carrying a balance
Zaki said that’s the next question for researchers to look at. In the meantime, people can do some calculations to get a better handle on their own finances.
To estimate the dollar cost of a card purchase (which you plan to finance), treat it more like an installment loan, such as an auto loan or a mortgage.
- Figure the monthly payments you can make over the term you plan to repay the balance, and add up the monthly interest charges.
- Calculators will help crunch the numbers, such as the balance payoff calculator at CreditCards.com
- Once you’ve calculated your interest cost, add it to the price of the item and ask yourself, “Would I buy it at that price?“
Zaki used an example of two TV sets to illustrate.
- In both cases, the interest rate is 15 percent and the buyer can afford to pay $25 a month.
- In this scenario, a $400 set would cost about $50 to finance, and it would take 18 monthly payments to pay it off. Total cost, about $450.
- For an $800 set, the interest cost more than doubles. At payments of $25 a month, interest costs are nearly $230, and it would take 42 monthly payments to pay it off.
- That puts the total cost of the more expensive set over $1,000.
Worth it? Go with the cheaper set? Or should you save up for a while to knock down the interest cost?
It’s still a decision to wrestle with, but knowing the dollar cost of financing will help.