Mental Accounting
July 8, 2008 – 6:07 am
We all have inherent flaws in our thinking, which I suppose keeps all of those psychologists employed. 
Mental accounting is a way that we (typically) categorize our finances based on certain circumstances. This type of thinking can occur in several different ways, and you should be guard when these types of situations occur.
“Free Money”
Do you consider unexpected money “free money?” For example, if you get a tax rebate or a tax refund do you consider it free money, and then go ahead and spend it on something that grabs your attention?
Sales
Buying something on sale doesn’t necessarily save money. “I saved ten dollars on $40 sweater.” You saved money? Really? Which bank account is it in? “I saved ten dollars on $40 sweater” doesn’t mean you saved ten dollars. You simply purchased a sweater for $30. You didn’t save anything. You spent $30. And have you ever decided to spend some of the money you “saved?” I have.
Big Ticket Item Mistakes
We all need to be more careful on large ticket items, because we’re more likely to include extras as part of larger purchases than we would be if we were buying the extras by themselves. For example, most of us would be more likely to pay for extras on new car purchase than we would be to upgrade our current car. After all, a $300 upgrade stereo system doesn’t seem like that much on a $30,000 car, but spending $300 out of pocket to upgrade the stereo in your current car seems like a more expensive proposition.
Mental Account Based On the Source Of Funds
If you receive an inheritance, do you think of that money as “dad’s money”, or “mom’s money?” The fact is that these funds are no different from your normal income or investment funds. It’s easy to categorize these funds separately though, and make decisions on how to use or invest these funds differently based on where they came from.
Use Of Credit
Do you have money in a savings account and a balance on your credit card? If so then you are clearly a victim of mental accounting. I’m not against keeping a small emergency fund in cash while you pay of your credit (cards), but I know some of you out there have $20,000 sitting in cash somewhere while slowly paying your outstanding debt. This makes no sense! I understand that you feel like the cash gives you security, but it doesn’t. It would be better to use most of these funds to pay off your outstanding debt, and then increase your emergency fund once your debts are paid off.
I struggle with some of these issues, and it’s a constant battle to evaluate financial decisions with a critical eye. But remember, diligence is rewarded!
Image Credit: Image Editor
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3 Responses to “Mental Accounting”
I struggle with the large ticket items as well. When we purchased the last tv, I was thinking about getting the best features for the best deal. Well, I also was thinking that this tv should last for at least 10 years and we should get the best one we can afford now. Then I started to rationalize that we don’t go to movies that often and that we could create a home theater experience. Also, credit plays a factor as well. My budget was to pay cash for our new tv, but if credit was used, the costs would skyrocket. It’s easy to get carried away. Great post!
By Scott on Jul 9, 2008