For those unfamiliar with the Prisoner’s Dilemma, it’s essentially a hypothetical scenario where a prisoner has to choose between two alternatives – rat out his accomplice or say nothing. The prisoner selects which action to take based on the potential payoff or outcome from either alternative.

The Prisoner’s Dilemma is a common way to explain a branch of economics called Game Theory or Industrial Organization, popularized in the movie A Beautiful Mind. John Nash realized that to reach an optimal outcome, no participant can be made better off by choosing a different course of action. Essentially, everyone is in the best place that they can be.

So how does this apply to personal finance?

Let’s use credit card companies as an example. ACME Credit Cards has a large marketing department who has one simple responsibility – convince you that the optimal outcome is using a credit card.

So let’s use game theory to analyze the true payoffs of using and not using credit cards. I’ll then show you how ACME Credit Cards has distorted the truth hoping that you’ll choose a non-optimal solution (though certainly optimal for them).

Setting up the participants and outcomes

Step 1 is setting up the game with the possible choices that each participant has.

As shown above, Consumers have the option to either use credit cards or use cash for purchases. For the purpose of this illustration, I am narrowing the Credit Card Issuer’s options to make money from either interest charges or transaction fees charged to merchants (this assumes that the Consumer pays off the balance in full each month).

Step 2 is setting the payoffs that each participant can expect depending on the outcome of the choices made.

Here is a recap of the outcomes:

• If the Consumer chooses to use credit cards and not pay off the balance each month, then the Consumer pays interest charges and the Credit Card Issuer makes huge profits. Bad outcome.
• If the Consumer chooses to use credit cards and pay off the balance each month, then the Consumer still pays more since Consumers spend on average 18% more when using credit cards versus cash and the Credit Card Issuer still makes money. Bad outcome.
• If the Consumer chooses to use cash only, then he or she saves money and the Credit Card Issuer goes broke no matter what it chooses. Good outcome.
• Optimal Outcome: The Consumer should always choose to use cash instead of credit.

Step 3 is setting up the outcomes as Credit Card Issuers would have you believe them.

Here is a recap of the outcomes:

• If the Consumer chooses to use credit cards and not pay off the balance each month, then the Consumer  was able to get just what he or she needed when he or she needed it and the Credit Card Issuer is the good guy. Good outcome.
• If the Consumer chooses to use credit cards and pay off the balance each month, then the Consumer was still able to get just what he or she needed when he or she needed it and the Credit Card Issuer is the good guy. Good outcome.
• If the Consumer chooses to use cash only, then he or she misses out on all of the rewards and fun that everyone else is taking advantage of and the Credit Card Issuer goes broke no matter what it chooses. Bad outcome.
• Optimal Outcome: The Consumer should always choose to use a credit card instead of cash.

Avoiding the marketing traps

Do not be fooled by slick advertising. Although Credit Card Issuers paint a very pretty picture of instant gratification, reasonable fees and interest rates, and a mass of incentives (e.g. miles, points, cash back), the reality is that they are making a lot of money. Visa posted profits of $713mm just for the first three months of 2010!

Meaning, they are doing a great job of distorting the truth. As shown above, the actual outcomes are not fun and fancy free living. Rather, avoiding credit and debt is the sure path to financial stability and growth.

This same logic and process aptly works for other areas of personal finance as well. I just like picking on credit cards.

Also, listed below are several articles and ideas on how to avoid debt and save money:

• How To: Get out of debt using the Snowball Method
• 6 More ways to stop overspending
• The 30-Day “No Spend” Challenge
• 4 Changes to make in this new economy

What are some other examples where the optimal outcome is being distorted by clever marketing? Also, sign-up for our RSS Feed for timely updates on this and other financial topics.

I like marketing. I market my website. I market myself to potential employers. I marketed myself to my wife and she fortunately bought. I believe marketing helps us gain knowledge of products, services, and opportunities that we might not have otherwise known about.

I believe marketers spend everyday trying to open our heads and rewire us to buy their stuff. I’m not cynical and I don’t think they are evil or bad people. However, as consumers we need to understand that they want our money and that it is Us vs. Them. My six reasons.

1) Discount pricing is a marketing ploy

I spent some time working at a major, national retailer. I’m not interested in pointing fingers, so let’s just call it Brand X. While working at Brand X, I was involved in many pricing conversations and observed the pricing process. We all know that stores use discount pricing as a means to incentivize you to buy now. I didn’t understand how deep that really runs though. For example, if a shirt or sweater costs the company $10 and they know from historical reports that consumers typically will only buy it at a price of $20, then they price it at $40. That way, they can discount it at 50% (oh my gosh! oh my gosh! oh my gosh!) and it will sell at the expected price of $20. Meaning, they don’t even expect you to pay $40! If you do buy it at $40, then you just lost. If you purchase at $20, not because you need the item but because you can’t pass up that great price, then you just lost.

2) They make us ask permission to buy from them

I’m borrowing this reason from Dave Ramsey and don’t take the credit myself. Banks, car dealerships, etc need us to buy from them in order for them to make money. And yet, we find ourselves asking them, and almost pleading at times, to take our business. They tell us that we’ve been “approved” so that we feel part of the club. “Honey, great news! The bank approved of us.” They put on a great dog and pony show to make us anxious that we might not get the “deal.” Stop and realize what is really being sold. Often, what’s being sold is enslaving amounts of debt. Liabilities, like cars, that masquerade as assets don’t make you happy. Money in the bank and peace of mind make you happy. Walk away next time someone tries to get you to say, “Please, can I have your stuff? Please, can I buy some debt?”

3) Research, research, research

Marketers spend a considerable amount of time learning their trade and then studying consumers’ behavior. Any good professional would. They track and analyze your buying and browsing behaviors, study psychology, and attempt to gain an intimate understanding of you. This is a double-edged sword. For example, Zappos.com is very customer centric. They are almost obsessively customer centric. They use an intimate knowledge of customers to better meet customers’ needs. But at the same time, these marketing departments use this knowledge to optimize the entire buying process to get you to buy. So what am I saying? Simply that marketers are constantly gaining new information about us and using that information to create extremely enticing advertisements. Just to put this effort into perspective, advertisers are expected to spend $242 BILLION on ads in 2009 alone. They have to recoup that investment and they expect to have us, the consumers, foot the bill. Don’t buy just because of the shiny ad.

4) They use fancy or technical names that confuse the issue

As the title suggests, a rowing machine is now a “1205 Precision Rower,” which sounds much cooler. Another example is the 12b-1 fee charged by some mutual fund companies. Rule 12b-1 was adopted by the Securities and Exchange Commission (SEC) in 1980 and allows fund companies to pay for sales and marketing activities by charging you a fee. This is in addition to the normal or stated expense ratio. It bothers me that fund companies charge consumers a marketing fee but don’t call it that. I understand that the name is derived from the SEC rule, but it is misleading to novice investors who are just starting out. Just call it a marketing fee so we can decide if we want to pay it.

5) “Where’s the pain?”

Another double-edged sword. A good marketer asks and answers the question, “Where’s the pain?” If a marketer can understand the problem a consumer faces, then he or she can develop a campaign or product that addresses that problem. Target pharmacy bottles are an excellent example of a marketer adding value to a product. Several years ago, Target redesigned its pharmacy bottle to make it easier to open, identify the prescription, and know to which family member the prescription belongs using color coded cap rings. The added convenience is worthwhile. On the other end of the spectrum, think about all of those late night infomercials. They offer solutions to common problems via their products. But stop and think to yourself, “Yes the Magic Bullet makes life a little easier for me, but my blender works just fine. So I don’t really need it even though it is newer, nicer, faster, etc.” In other words, they may be offering something that solves a problem, but you just may not really need the problem solved (at least not at the expense of your retirement). So next time you go to buy a product that you really don’t need, decide to put the money into your retirement account instead.

6) Illegitimate or illegal marketing schemes

I don’t want to dwell much on this topic since my purpose with this post is to address legitimate marketing efforts. However, there are a lot of marketers of ill repute out there attempting to bypass the law and cause you to lose your money. If you suspect that an offer is too good or just doesn’t seem right, please avoid it. Also, you can check sites such as Scam.com, ScamBusters.org, Snopes.com, or the Better Business Bureau to see if others have reported the offer as a scam.

Conclusion

Let me reiterate an important point – I have nothing against marketers. I know a lot of them. They have families, homes, dogs, and probably some consumer debt themselves. But buyer beware. Every institution, firm, corporation, etc must maintain a healthy revenue stream and that revenue has to come from someone. See it as a game. You are allotted X number of dollars each month to support yourself and your lifestyle. Marketers setup storefronts where you can choose to spend your dollars. At the end of the game, the person or store with the most dollars wins. The more you keep to yourself, the greater your odds are of winning.

Let me know in the comments if you agree or disagree.

I came across Credit Karma about a month ago and decided to sign-up to evaluate the service. Basically, Credit Karma provides you with your credit score and an analysis of your credit report for free. I’m not talking about 30 days for free and then you pay “only $9.99 a month after that.” I’m talking about 100% free – forever. Well, at least while their sponsors continue to pay the bill.

The concept of Credit Karma is almost foreboding. The name itself refers to the fundamental concept of karma – what goes around comes around. Meaning, your actions today will affect your credit score tomorrow. So, can Credit Karma help you create some good karma? I’ve broken down my review into several key questions.

How is it free?

The service is completely free due to advertisers. Companies like Geico, Charles Schwab, and State Farm Insurance pay the bill for your credit score in order to place ads on the site. Meaning, no credit card required. One of the benefits of Credit Karma is that the ads/offers are targeted and voted on. By providing your information, Credit Karma determines which offers are most relevant to you. Further, members are able to vote on whether or not an offer is valuable. One important note is that Credit Karma will never disclose any personal information without your permission. Meaning, advertisers cannot determine who you are unless you sign-up for an offer.

I personally believe that the offers are valuable to consumers for two reasons. First, you have access to valuable credit information for free. Second, you are made aware of financial offers that you may not have otherwise known about.

What services are offered?

Here is a brief highlight of the main services that Credit Karma provides.

• Credit report card – Your credit report card is an analysis of your open credit card utilization, percent on-time payments, average age of open credit lines, total accounts, hard credit inquiries, total debt, and debt to income ratio (for more information on these areas, read this post). For each area, you are given a grade, A through F (I got a “D” for average age of open credit lines). This might bring back nightmares of grade school, but it also gives you a great insight into which areas you need to improve. Think of this page as your action plan.
• Credit score and snapshot – You also receive your credit score from TransUnion, which can be updated as often as you’d like. Credit Karma graphically tracks your score over time to let you know how you are progressing. My score jumped 16 points over the one month period! The credit snapshot is a view of how lenders view your credit score as compared to the national distribution of scores.
• Credit score comparison – This feature is just cool (though it may lead to an increased ego or just crush you). Your score is compared against all other Credit Karma users, just users in your state, users in your age group, and users that use your same email domain (I’m in the 76th percentile as compared to other Gmail users, argh).
• Credit simulator – If you are wondering how different actions will affect your score, Credit Karma provides 14 different attributes on which you can run simulations. So for example, how does adding a new credit card affect my score? Well, I checked and it decreased my score by two. Sorry American Express, no card this Fall. The 14 attributes fall into three general categories: Credit Limits, Payments, and Records.
• News articles, tools, and financial calculators – There is also a feed of news articles related to credit, tools, and a host of financial calculators.

All and all, I found the offerings to be very insightful and worth being served unobtrusive ads.

Does it affect my credit score?

Okay, so I’m very paranoid about doing anything that would affect my credit score unless I need to. So I emailed Credit Karma and asked if checking my credit score through them would affect my score. Here is their response, “No. Credit Karma is making the credit score request on your behalf. Inquires made on your behalf will not be shown to creditors and will not affect your credit score.” Meaning, check back often to see how your score and credit report are doing. You don’t want a mistake to go too long without notice.

Summary

I strongly advocate taking good care of your credit score since it has the ability to open and close doors (new home, new car, job, apartment, low interest rates, etc). Credit Karma offers an excellent service at a genuinely free price. Go check it out.

If you still have more questions, follow this link to Credit Karma’s FAQ page or email them.

(This post is featured in the Carnival of Personal Finance #219 – Little League Edition)

While doing a bit of car shopping a few years back, the car salesman asked my wife and me if we had had a loan before, if we knew our credit score, and how old we were. We told him that we hadn’t had a car loan or mortgage but that we had excellent credit.

A few minutes later, we were told to speak with a new salesman. When I asked the new salesman why we had been handed off to him, he told us, “I’m the guy that helps people with poor credit.” At that point, I about walked out the door. Just because we were young and “appeared” to have no credit history, this salesman assumed we had poor credit and never would have suspected that I had a credit score of 800 and would have no problem credit qualifying! Now mind you, I was 24 at the time.

On our way out the door, I spoke with the original salesman and expressed my frustration with being reassigned to the “poor credit” guy. When I told him my score, he asked how I had ever managed that.

So what did I do, and what can you do to increase your credit score?

First, you need to understand what the credit agencies are considering. There are essentially five factors with corresponding weights that determine your credit score.

1. Payment Record (35%)
2. Total Amount Owed (30%)
3. Credit History (15%)
4. Application History (10%)
5. Credit Mix (10%)

As you look at that list, keep in mind that the objective of each credit bureau is to generate a number that tells a creditor how safe they are when extending credit to you. In other words, your past and current behavior indicates how likely you are to repay the borrowed amount on the agreed schedule. Now let me explain what each area above entails and what you can (and should) be doing to help boost and maintain your credit score.

Let’s dive deeper into each factor of your credit score

Your Payment Record shows how consistently you pay your bills on time. As you can see, this is the largest factor when determining your credit score. Creditors want customers who they can expect to always pay the bill by the due date. So what we are really talking about is your self-control. If you have enough self-control to not overextend yourself, then you will be able to meet your current and future obligations. If you do not live within your means (i.e. spend less than you make), then you will have a poor payment record showing late payments.

Let me give you quick tip if you do have some late payments showing up on your credit report. First, speak with the creditor about having the negative information removed from your credit reports (assuming you have reconciled with the creditor). If you have a single blemish, then they are usually pretty willing to work with you. Second, appeal directly to the credit bureaus to have the late payment information removed, especially if there was any mistake on the part of the creditor. For example, Old Navy once didn’t send me my monthly statement. I didn’t think anything about it until the next month when I found out I had a late payment due. I spoke with Old Navy, made the payment, and reconciled everything with them. Sometime later, I discovered the late payment on my credit report. I disputed the late payment with the credit bureau by explaining the situation in about 50 words and the late payment was promptly removed from my credit report.

Second, your Total Amount Owed is an indicator of your current ability to meet future obligations. For example, someone who has $1,000 in debt is probably more likely to be able to handle additional debt than someone who has $10,000 in debt. You should consider your total amount owed by calculating your ratio of credit used to total credit available. So, if your total credit limit (once you add up all of your credit limits) is $20,000 but you only have $2,000 in used credit, then your ratio is 1 to 10 or 10%. Again, this metric is a measure of self-control. Just because you have available credit, you do not have to use it. Creditors want to know that you are not maxing out your cards and taking on “too much” debt. A simple rule of thumb is to keep your ratio of credit used to credit available below 20%.

Third, your Credit History is determined by looking at all of your credit accounts. Creditors want to see that you have had other credit accounts for a long period of time and that the accounts are in good standing. Meaning, you need to have credit accounts that have been open for many years. The credit bureaus prefer to see accounts that have been open for literally decades. For example, I have a card that has been open and in good standing for over seven years, which is considered “too short” by the credit bureaus. Therefore, leave your credit accounts open even if you are not using them. This also helps to decrease your credit used to credit available ratio. One caveat, don’t have too many credit accounts open. If you have quite a few cards and need to close some, just close recently opened cards.

Another important part of your credit history is showing that you have used your credit. Sometime ago, I had Trilegiant perform an analysis on my credit (more info on Trilegient in another post). One of the critiques that I received was not using my oldest credit account. So even though the account had been open for years and had a great payment history, the lack of use was not helping my credit score. Meaning, use your credit accounts from time to time even if it is just a small amount.

Fourth, your Application History is a record of how often and how many times you have checked your credit (also known as “inquiries”). The logic is that if you are frequently checking your credit, then you intend to use it and potentially overextend yourself. There is no perfect number of times of how often you should check your credit in a given time period. However,  inquiries are removed from your credit report after 24 months (though only impact your credit score for 12 months). A good rule of thumb is no more than 3-5 inquiries in a 12 month time frame.

The last factor is your Credit Mix. Credit is grouped into different types: installment and revolving. Installment credit is credit that has a fixed number of payments, so basically a loan. Your mortgage, auto loan, personal loan, or student loans are all types of installment credit. The other type, revolving, does not have a fixed number of payments. Most know revolving credit as credit cards or department store cards. Having a mix of credit shows that you know how to handle different types of credit. Also, try not to have too many credit accounts of one type (e.g. Kohl’s, Macy’s, Sears), which can decrease your credit score. If you are able to diversify your credit mix, then you are more likely to receive additional credit later.

Managing your credit is essential since so many things depend on it

You should evaluate the current status of your credit score and credit report for growth opportunities. Then, create a written action plan to improve your credit.

For additional information on improving your credit score, I’ve posted a brief YouTube video title “How to Improve Your FICO Score.”

(This post was featured in the Carnival of Twenty Something Finances)

My social security number is 457-55-5462. Wait, that’s actually Todd Davis’ social security number. Mr. Davis, CEO of LifeLock, has challenged every ill-intentioned malcontent to try to steal his identity. He is so sure that LifeLock can and will prevent identity theft that he shouts his social security number every chance he has. At $10 a month, is LifeLock something you should consider?

We have all heard the reports that identity theft is a common and growing problem in America. So what does LifeLock do exactly?

1. Set free fraud alerts with credit bureaus if you suspect your identity has been stolen
2. LifeLock will continue to set fraud alerts every 90 days unless you tell them otherwise
3. Remove your name from lists of pre-approved offers for credit cards and insurance
4. Order your free credit report annually for you
5. Using WalletLock, they will contact all of your credit/debit card companies if your wallet is stolen
6. Using eRecon and TrueAddress, LifeLock monitors criminal websites and nationwide databases for your personal information
7. If your identity is stolen, you are covered by a $1 million service guarantee

LifeLock readily admits that several of the services that it offers are free to the public, but recommends using a professional to manage it for you. So what can you do for yourself?

1. You can set a fraud alert with each of the three major credit bureaus for free. Call 1-888-397-3742 for Experian, 1-800-680-7289 for Transunion, and 1-800-525-6285 for Equifax).
2. You can reset your fraud alert every 90 days following the same links above.
3. Use OptOutPreScreen.com to remove your information from pre-approved lists. Use DoNotCall.gov to remove your phone numbers from telemarketers call lists (something LifeLock does not do).
4. Every consumer should visit AnnualCreditReport.com each year for a free credit report from Experian, Transunion, and Equifax (make sure to bookmark). I also recommend paying the $7-8 to see your FICO score (just make sure it’s the FICO score you are seeing). Another option is Wells Fargo Identity Theft Protection provided by Trilegiant which offers three credit reports, three credit scores, an analysis of your reports/scores, daily monitoring, and $10,000 identity theft insurance. After a 30 day free trial period, the monthly fee is $12.99. You can cancel during the 30 day trial and still receive the reports, scores, and analysis. You can also sign-up and cancel as many times as you want. Just call 1-888-877-1605 or visit Wells Fargo for more information.
5. If you lose your wallet or purse, then IdentityTheftLabs gives step-by-step instructions on how to minimize victimization.
6. If you are already paying for credit monitoring through companies such as Equifax, then you can often have them monitor criminal websites for your personal information free of charge.
7. Many credit card companies offer a credit protection plan for a fee that includes identity theft coverage. For example, one of my cards offers a Debt Protection Plan for a fee of $0.55 per $100 that I spend each cycle (we usually pay $4-7 each month). If I am a victim of fraud, then I am assigned a dedicated agent that helps me through the resolution process. And the identity theft does not have to be related to that account. I can also order a free credit report twice a year. So we don’t quite have $1 million coverage, but we do have some protection as well as other benefits in case I lose my job or have a baby.

So as you can see, much of what LifeLock does you can do for yourself. LifeLock, however, offers automation, simplicity, and an undeniably large guarantee. Whether you decide to use an identity theft protection service or handle everything yourself, simply remember that you are ultimately responsible and in charge of your own identity. Make sure to use good common sense and you can avoid many prevalent pitfalls. If you are looking to compare popular identity theft protection services, then visit the IdProtectionGuide.

(This post was featured in Carnival of Pecuniary Delights Edition #20 hosted by Counting My Pennies)