When you pay by cash, the pain is the highest and when you pay by credit card, the pain is reduced considerably.
'An ex-taxi driver bought a painting for $170 million'.
The newspaper headline caught my eye. The news inside was even more interesting.
The former taxi driver, now a Chinese billionaire, had paid for the painting through his credit card.
That's a $170-million transaction through a credit card!
It set me thinking. When billionaires spend money through credit cards, are they prone to making the same mistakes that ordinary people make?
When you pay for buying anything, it detracts from the pleasure of buying and consuming that item.
Behavioural economist Dan Ariely has described this as the "pain of paying" or a moral tax on consumption.
When you pay by cash, the pain is the highest and when you pay by credit card, the pain is reduced considerably.
Hence, it is most difficult to overspend when you pay by cash, as the pain of paying is the highest. As the pain of paying is the least when you pay through credit card, chances are you could overspend.
To understand this, imagine you have had a lovely but expensive dinner at a five-star hotel.
When the bill arrives, you will pay by credit card. Now, imagine paying the tip in cash rather than signing it on the charge slip.
Try this next time if you have not already done so. Invariably, you will leave a smaller tip when you pay cash.
This is the principle of introducing the "pain of paying" to curb overspending.
Debit cards fall between cash and credit cards.
They do reduce the pain of paying compared to cash but the mental image of your bank balance depleting immediately (buttressed by the SMS announcing your reduced bank balance) is definitely more painful than in the case of a credit card.
That is the main reason why shopkeepers don't mind accepting payment by credit card, even though they need to pay around one per cent as fees to the credit card companies.
They know they will more than make up for it by selling more or higher-margin products.
It would be interesting to speculate whether Liu Yiqian (the Chinese billionaire) would have bid less for the painting if he had been required to pay immediately, instead of by credit card.
It is possible that billionaires are prone to overspending when they use a credit card.
Liu can afford to overspend but most of us need to curb it. The lesson for lesser mortals is not that credit cards are bad. They are an incredibly useful product.
Can you imagine carrying around wads of cash if required to make an emergency purchase?
Even a debit card might not be able to help if you need to make payment of the initial deposit for an emergency hospitalisation or buy expensive tickets for last-minute travel.
So, having a credit card definitely makes sense.
To curb overspending, there are many ways by which you can introduce the pain for yourself before you whip out a credit card to pay.
The easiest is to use the facility some banks offer, to voluntarily reduce your credit limit.
The card issuer allows it to be increased easily enough by making a phone call or sending an SMS, so that it is not an impediment during an emergency.
But, the fact that you have to take an additional step by itself introduces 'pain' and, hence, curbs overspending in normal circumstances.
You can also create rules for yourself such as no payment by credit card unless it is a pre-budgeted item.
If you have made a shopping list with a budget in advance and stick to it, you are unlikely to overspend only because you are paying by credit card.
In fact, even being consciously aware that you might overspend is by itself likely to introduce some constraints on your credit card usage.
You can work out your own method to introduce some pain of paying while using credit cards, so that you can continue to have this product in your wallet but at the same time, can curb overspending.
The writer is a registered investment advisor.
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