What is mental accounting?

People think about money differently based on how it was earned or where it will be spent. For example, you may carefully budgetBudget A monthly or yearly estimated plan for spending and saving. You work it out based…+ read full definition how you spend your paycheques, but be more spontaneous with how you spend a taxTax A fee the government charges on income, property, and sales. The money goes to finance…+ read full definition refund or bonus. This is called mental accounting. 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…+ read full definition.

How does mental accounting affect financial decision-making?

There are a few ways mental accounting can affect financial decisions, including:

• Budgeting – Keeping track of your income and expenses is an important part of managing your finances. Budgeting is a form of mental accounting which consists of setting limits for expenses, such as entertainment, to prevent you from overspending. However, this form of mental accounting can be problematic if you follow limits too strictly. For example, if you under-spend in one part of your budget, then you could use that money elsewhere – you could save it, use it to cover a surprise expense, or cover higher spending in other areas of your budget. But many people might overlook this flexibility once they have mentally assigned an amount of money to a specific budget category.

• Substitution – Money can be used for any purpose regardless of which mental accountAccount An agreement you make with a financial institution to handle your money. You can set…+ read full definition 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 would treat these winnings as distinct from your regular income and spend it differently. 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 – How you feel about spending money can influence your behaviour. It’s fun to eat at a restaurant, until the bill arrives. This is called the pain of paying. Studies show that people feel different levels of ‘pain’ depending on the payment method. For example, you are more likely to overspend when you use a credit card instead of cash because cash in hand is more tangible than credit. This is despite the fact that a dollar spent with cash is equivalent to a dollar spent with credit.

How can you use mental accounting to help you reach your financial goals?

There are several ways you can use mental accounting to your advantage, including:

• Create a formal budget – Rather than keeping mental accounts on how you spend your money, outlining all of your expenses in a structured budget can help you keep track of your financial goals. Try a budget worksheet to help you get started.

• Windfall reality check – If you come into extra money (known as a windfall), pause before spending it all on a fun purchase. Consider your budget, debts, and what important expenses you could cover — or investments you could make — with the added dollars.

• Plan for unexpected income – Creating a plan for how you treat irregular income such as tax returns or bonuses can help you avoid viewing the money as disposable and instead put it towards your financial priorities.

• LiquidityLiquidity Refers to how easy it is to change an investment or asset into cash, without…+ read full definition courage – If you’re having trouble sticking to a budget, try making your purchases with cash instead of your credit card. Use the pain of paying to your advantage and it’s likely that you’ll spend less over time.