What do chocolate and debt have in common?

Table of contents

Why is it so difficult for us to eat fewer sweets? Why do so many want to quit smoking but mostly fail? Why do we always study for an exam at the last moment?

The Present Bias…

Presumably everyone has, more than once, postponed something to tomorrow that could well have been done today. It's human and yet somehow tedious. This phenomenon is well known in behavioural economics: One speaks of the so-called hyperbolic discounting or the present bias. This means that we prefer to reward ourselves today rather than tomorrow because we misjudge future risks.

Here is an example with the following two questions. Would you rather receive £100 today or £102 tomorrow? And: Would you rather receive £100 in 10 days or £102 in 11 days?

In the first case, most people choose £100. In the second case, however, they prefer the £102. The question is the same in both cases: Are you willing to wait a day to get £2 more?

The possibility of receiving something today - now - changes the decision. And so comes the dilemma. If we ask the two questions again in ten days, most people will again choose the hundred pounds in the first case. The £102 are therefore never taken, although objectively it might be the better decision.

It works the same way in everyday life. We postpone the start of a diet, quitting smoking or studying for the exam until tomorrow - and postpone it tomorrow until the day after tomorrow. And so forth.

... also a debt trap
What effect does bias have on our financial decisions? We tend to overestimate the benefits of a purchase decision today and neglect the future costs. Or in short: We think too short-term. So we tend to buy too much. If the money is not in our account, this quickly leads to a debt trap through borrowing.

The joy of the newly bought or leased car is huge, the future instalment payments and debt interest on the loan taken out are still a long way off. The purchases do not necessarily have to be large. Paying for smaller expenses like a beer after work with a classic credit card is possibly more dangerous. After all: It's only a few pounds.

Of course, present bias isn't the only reason people can accumulate too much debt. Whatever the cause - the following question seems important to me. How can you avoid falling into the debt trap?

Tip 1: Use debit cards & buy prepaid credit cards

Simply resolving to think longer-term in the future is probably not enough. These “basic instincts” are likely to be programmed too strongly in many of us.

Another strategy is more promising. How can I best resist the temptation to eat the bar of chocolate? I can set my mind to it - and probably fail. But a better option would be to not even have the chocolate in the pantry.

This principle works in a very similar way when spending money. I haven't had a classic credit card for several years. Instead, I rely on debit cards that are linked directly to my bank account. On the other hand, I use prepaid credit cards that I have to top up beforehand via bank transfer. I can only afford things if I actually have the necessary money in my account or on my prepaid credit card.

Tip 2: Use different accounts

Prepaid protects me against my impatience to want to own things today instead of tomorrow. But it does not protects me either against unexpected costs or against bills that I simply forgot. For example, high medical costs due to illness or the annual tax bill.

That's why I've had several accounts or cards for different types of expenses for a long time. I use my salary account, probably like most people, for daily use. A prepaid credit card serves as my holiday account and I use the third account for larger purchases. Others would be conceivable, for example for healthcare costs or taxes.

This subdivision facilitates your own budget planning in a simple way because you get a better overview of the expenses incurred.

Tip 3: Set up standing orders

Ideally, we also set up monthly standing orders from our payroll account, which are triggered immediately after the wages are received. An example: Anyone who receives a salary of £5,000 a month can automatically transfer £500 to their own tax account the day after, trigger the rent payment, pay £200 into the holiday prepaid credit card and £200 for unexpected medical expenses.

This has two positive effects. First: The money is basically out of sight, out of mind. The probability that you will then spend this money on daily consumption is significantly lower. Secondly: You will no longer be surprised by larger expenses if you pay for holidays, taxes, medical expenses, etc. in specially created accounts and pay fixed costs such as rent or mobile phone and internet subscriptions in the same way.

Conclusion: Trick yourself

The present bias means that we prefer to reward ourselves today rather than tomorrow. We buy things that we actually can't afford. To make matters worse, shopping is now easier than ever. We can pay cashless online with a credit card at virtually any time, which increases the risk of debt.

Only paying with cash is probably only practical for a few. On the other hand, it is easy to use debit cards and prepaid credit cards. Combined with multiple accounts for different types of expenses and standing orders, we make it harder to fall into debt.