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 taxTax A fee the government charges on income, property, and sales. The money goes to finance government programs and other costs.+ read full definition returns or inheritanceInheritance Property, money, titles, or debts that pass to you after someone’s death.+ read full definition. This is called Mental AccountingMental Accounting The reasoning process people use to track their income and various expenditures. This process is influenced by how money is obtained and what it is usually spent on. It affects how people make decisions about their money and can lead to irrational decision making.+ read full definition and it significantly affects how we choose to spend, save and investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition.
Here are some examples of how mental accounting affects your financial decision making:
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 budgetBudget A monthly or yearly estimated plan for spending and saving. You work it out based on your income and expenses.+ read full definition.
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 debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition to make up the deficit.
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.
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.