Cash or card? Financial literacy leads to better decision making

We all make financial decisions in our everyday life, both big and small. But being familiar doesn’t necessarily make us experts on the topic. We live and breathe money talk at FundCalibre, but I often find myself double-checking things on Google! The fact of the matter is that managing your money and making sound financial decisions is difficult. One challenge is the ready availableness of credit cards. It’s surprisingly easy to get into debt quickly, without a basic understanding of money.

“Financial illiteracy is not an issue unique to any one population. It affects everyone: men and women, young and old, across all racial and socioeconomic lines. No longer can we stand by and ignore this problem.” — US President’s Advisory Council on Financial Literacy

What is mental accounting?

Mental accounting plays an instrumental role in helping us make financial decisions and explains how we treat money differently, depending upon its source and its intended use. Here’s a classic example:

Imagine you just arrived at a cinema and, as you reach into your pocket to pull out the £10 ticket you purchased in advance, you discover that it’s missing. Would you fork out another £10 to see the movie?

Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the cinema, you discover you had lost a £10 bill on the way. Would you still buy a movie ticket?

In both scenarios the loss is £10. However, more people would be willing to buy a ticket in the latter case, compared to the former.

Mental accounting also explains why small windfall gains, like a £50 lottery win, or a cash gift are more likely to be spent easily, as they are considered unexpected gains. This mental accounting is important in understanding how we use credit cards.

Should I use credit cards or cash?

Credit cards essentially “decouple” the purchase from the payment because you are not physically parting with any money, and the payment occurs at a later date. They also make individual purchases less important, because a £50 purchase on a final bill of £1,000 is less impactful. Credit cards encourage spending because they reduce the pain of paying.

So, is using cash a better way to control our spending? In some ways, yes, because there is a split second of time to reconsider our purchase when we reach into our pockets and have to hand it over. Studies have also shown that it is easier to budget if you take out a certain amount of cash each week and can only spend that amount, no more.

But studies also show that our attachment level to purchases is higher when we pay with cash. We are creating a memory, which sometimes means we are willing to pay more because it makes us feel good. And, in today’s society – which is becoming more and more cash-less – it is sometimes not even possible to pay by cash at all.

And that brings me on to the likes of Apple and Google Pay. Both take ‘distance purchases’ to a whole new level. I don’t even need to get my card out of my wallet now – with the flick of my wrist or the tap of my phone I can pay for pretty much anything I like, seemingly without a care in the world.

Spread your payments but keep a close eye on debt

If used correctly, credit cards offer an easy and affordable way to spread out expenses month by month. If used incorrectly, debt can quickly spiral out of control. A balance of £1,000, unpaid over the course of a year, soon becomes £1,200*. After two years it’s a debt of 1,430*. According to UK Finance, outstanding balances on credit card accounts have grown by 9.5% over the twelve months to April 2022**, and with the cost-of-living crisis intensifying, I can only imagine this number will get bigger over the coming months. Remember, compounding can also be a bad thing.

Learn more: 5 credit card myths you shouldn’t believe

Why is this important for investing?

For starters, you shouldn’t be investing if you have credit card debts that are spiraling out of control. Investing is the next step for those with no high interest debts (like credit cards) and a healthy emergency fund.

Sometimes, before you take the next step in your financial literacy, you need to take a step back. Healthy habits take time. Even if you’re not in a position to invest today, you can still start the learning process, so you’re better equipped in the future.

*Source: www.thecalculatorsite.com, £1,000 with 18% annual interest rate calculated monthly for one year.
**Source: UK Finance, Card Spending, July 2022