All money is created equal, but your brain doesn’t believe it. We tend to treat money differently based on how we obtain it or what we intend to spend it on. For example, we may carefully plan how we spend our paycheques but carelessly spend our tax returns or inheritance. This is called Mental Accounting and it significantly affects how we choose to spend, save and invest.
Here are some examples of how mental accounting affects your financial decision making:
Partitioning
One of the key aspects of mental accounting is that we divide our income into separate groups in our minds. We may partition our income into separate mental accounts for food, housing, transportation, shopping, entertainment and retirement savings. We then rely on these mental accounts to keep track of our spending across these different categories instead of thinking about our overall budget.
Budgeting
Using these mental accounts is a form of budgeting and it can help us keep track of our income and expenses. Budgeting is a very important part of managing your personal finances. Keeping a monthly mental account for food expenditures can prevent you from overspending on dining out or ordering in. However, mental accounts can be problematic when we follow them too strictly. When faced with an unexpected car repair, you could move money from other mental accounts into your “transportation” account but instead people tend to take on credit card debt to make up the deficit.
Substitution
Money can be used for any purpose regardless of which mental account it is stored in. Yet, many of us often refuse to substitute money from one account to another. For example, imagine that you win $1,500 dollars playing the lottery. How would you spend your winnings? If you are like most people, you treat these winnings as distinct from your regular income and spend it outside of your usual mental accounts. Instead of adding these winnings to your overall budget, the money is treated as disposable and spent on indulgences rather than necessities.
Pain of Paying
Mental accounting also impacts how we feel about spending money. Humans enjoy buying things, but the physical act of paying is unpleasant. We all love a good dinner out but may regret that extra appetizer when the bill comes. This is called the pain of paying. Studies have shown that making people focus on the payment process will reduce the amount of money they are willing to spend. For example, people are more likely to overspend when they use credit cards instead of cash. Since cash is more tangible than credit, we notice the change in our mental accounts immediately whereas the pain is somewhat deferred through using credit.
Key Point
Mental accounting can help you budget your money, but it can also cause you to make bad financial decisions.
Creating a formal budget can be a helpful way to stay on track with your expenses. We have a budget worksheet to help you get started.
