The Sneaky Way Credit Card Companies Get You to Spend More Money
Borrowing money is the reverse Robinhood
When I get a letter from my bank offering me an increased limit on my credit card, I’ll be honest: it’s a bit of an ego boost.
It feels good, especially since I spent most of my 20s repairing my badly damaged credit score after the financial crisis.
But, if you get a similar letter from your bank offering you an increase on your credit card limit — think twice before blindly accepting it.
There’s a good chance that you aren’t being offered this limit increase because your bank loves you — it’s a smart business decision on their part.
In this article, I review a research paper that clearly outlines one of the sneaky ways credit card companies trick you into spending more money than you should and provide tips on avoiding their trap.
The TLDR
Saving money means giving money to your future self.
Borrowing money means taking money from your future self
Credit utilization is a key factor in driving your credit score
When credit card companies offer you a higher limit, they know you’re more likely to spend money
Read to the end to learn the one-two punch to avoid “The Reverse Robinhood Effect.”
What it means to save and borrow money
According to the “lifecycle model,” economists expect people to use savings and debt to maximize the amount they can spend throughout their life. While this is not how any real person thinks about money, the lifecycle model does explain what it means to save and borrow money.
Saving money means taking money from your present self and giving it to your future self.
Taking on debt means taking money from your future self—it’s your future self who pays back the loan—so your present self can spend more money today.
Taking on debt today is rational if you know your income in the future will be high enough to repay the loan, fund your financial goals, and maintain constant spending.
This sounds nice, but in real life, when most people rack up consumer debt like credit cards, they have no idea what their future income will be. They take on the debt because it’s available to them.
A 2002 paper found evidence that the average person will spend more money when credit card companies increase the amount they can borrow.
The reason?
They believe that since they have been given a higher credit limit, this is a sign that they will earn a lot more money in the future. The reverse is also true; people interpret a lower credit limit as a sign their income may be lower in the future, and they spend less money today.
But don’t be fooled; credit card companies have no idea—and don’t care—what your income will be in the future.
Often, they increase your credit because you’ve done a good job managing your credit… so far. They correctly believe that when people are offered a higher credit limit, they will be more likely to spend it, which is how credit card companies make money.
Like a casino, credit card companies make money by tilting the odds in their favor and making large volumes of bets. In this case, they bet increasing your credit limit will cause you to spend more money.
And much like a casino, the house always wins.
The credit limit paradox
This is where your replacement-level finance blogger would give you oversimplified advice like “Never accept a credit limit increase!”
If only it were that simple.
Many people view debt as evil — which is nonsense. It’s simply a tool; it’s no more evil than a hammer or measuring tape. Most of us can’t afford to avoid debt our entire lives, so we must learn how to use this tool safely.
Your credit score is key in getting approved for loans with the most favorable terms. This goes beyond consumer loans like credit cards. A higher credit score can also get you a lower rate on a mortgage or a business loan — which can save you tens of thousands of dollars in interest.
One of the factors that determines your credit score is your “credit utilization,” which refers to how much of your credit you use. If your credit limit was $10,000 and you carried a $1,000 balance, your credit utilization would be 10%. If your credit limit was $20,000 and you carried a $1,000 balance, your credit utilization would be 5% — and your credit score would likely rise.
So, there are benefits from accepting a higher credit limit — but only if you can keep your spending in control — which credit card companies know is unlikely.
The research I referenced earlier found that people with low financial knowledge are the most likely to increase their spending when offered a higher credit limit because they view an increase in credit as a signal about their future income.
While people with more financial experience don’t spend more money when their credit limit goes up because they know that the way credit limits are determined is mostly Bull$hit and says nothing about their future financial prospects.
The Reverse Robinhood Effect
Robinhood is a folk legend famous for stealing from the rich and giving to the poor.
Borrowing money is the Reverse Robinhood.
Remember, the credit card debt you take on today needs to be repaid with future income. Borrowing money means robbing your future self and giving it to the credit card company — or, as I call it, the Reverse Robinhood Effect.
You must hold three simultaneous truths in your mind:
Credit card companies offer you a higher limit, hoping you’ll spend more money.
The people most likely to fall for this trap have low levels of financial knowledge.
Those who can accept a higher limit without increasing their spending have higher credit scores and pay less interest on their mortgage.
So, how do you avoid the Reverse Robinhood Effect?
A one-two punch of increasing financial literacy and improving your financial decision-making.
A one-two punch of increasing financial literacy and improving your financial decision-making. This is exactly what I cover in great detail weekly in the Money on my Mind Series.
I am curious what other people’s experience has been. Have you ever turned down a credit limit increase?
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.