Thursday, October 18, 2012

Mental accounting

Mental accounting causes us to be poor savers, extreme spenders, and poor investors.  Mental accounting is a common habit that sneaks up on us and influences our attitudes toward money.

Think of these situations:

- Grandma gives you $200 spending money for your birthday.  Do you convince yourself that your gift is a "free $200 off coupon" that you use to buy a new iPad for $600?

- You get your income tax refund.  Do you think of it as a nice windfall of free money you deserve to reward yourself with by buying something nice?

- Do you continue to carry a credit card balance that is charging you interest, yet at the same time continue to put most of your money into a savings account?

- Do you spend more money when you pay by credit card than you would if you paid by cash?

We are irrational beings and we do not treat all money the same.  Money is money.  It doesn't matter where the money comes from.  Its origin does not dictate it’s value.

Make yourself aware of the symptoms of mental accounting.  Treat any money that comes your way, regardless of its source, as money that you worked hard to earn.  

Having a budget and having targeted savings goals will help you keep your mental accounting under control. 

Here are some different attitudes towards the above situations:

- Grandma didn't give you that $200; you earned it.  Divide up this money like you would with your hard earned income.  

- Your tax return is actually a loan that you gave the government that is interest-free.  Why not use your tax return money to jump-start your emergency savings?

- It doesn't make sense to keep putting money into a savings account that earns 0.8% annual yield compared to being charged credit card interest rates at up to 29%.  Pay off that high interest debt!

Keeping close track 
of your expenses will help you determine whether you have the cash to cover any credit card charges.  Don't wait until you receive your credit card statement to know how much money you've been spending.  I prepay almost all of my credit card charges before my statement posts.  This is one way that helps me avoid any credit card debt.  

I'll charge something on a credit card and 2 days later the charge will post to my account.  Then I'll send money from my checking account to pay off my credit card debt immediately. 

Don't get me wrong; I am not against you buying nice things for yourself.  In fact, I believe and always encourage people to buy what makes them long as it's a thought out, budgeted purchase that was saved up for. 

I always advocate making purchases with your credit card, and then paying that balance off immediately with the money you've saved up in your checking / savings accounts.  Don't purchase something with your credit card if you don't have the cash on hand to pay off that balance.  Don't let mental accounting lead you scrambling to figure out how you're going to pay for the debt you've accumulated.

Don't forget, money is money.

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