The benefits and pitfalls of mental accounting

To get an idea of what we mean by mental accounting, ask yourself two questions: 

• If you got a $1,000-a-year raise from your job, how much of it would you spend?   
• If you got a $1,000 tax refund this year, how much of that would you spend? 

Are your answers to the two questions different? Chances are, a lot of people would spend most or all of the tax refund, treating it as a windfall and a chance to splurge a little. But they would save more, if not all, of the raise. After all, a $1,000 raise would be just $83 a month, before taxes. 

This is mental accounting, a mindset that treats money differently depending on subjective factors like where it comes from, what we’re using it for or how we feel about what we’re spending it on. But, in reality, money – no matter the source – is basically interchangeable. This tendency to mentally separate it into different accounts is what economists would call a behavioral bias, meaning that our behaviors and attitudes can affect how we view the value of money. 

Mental accounting often accounts for a lot of our behaviors as consumers. It can influence what we might consider to be a good deal, for example. Or it might make us feel like we are willing to pay a lot more for something if it’s part of a total experience, like movie popcorn or a ballpark hotdog. This sort of shifting value we place on the dollars we spend can change, but the actual value of one dollar versus another doesn’t. As a result, mental accounting can lead us to make some costly financial missteps. 

Let’s look at another example. Say you get a $1,000 bonus and, with the best of intentions, put the money away into a savings account. Meanwhile, you’re still paying down a high-interest-rate credit card every month. That means your savings are earning you 5% or less, but you’re still paying a monthly debt at 20% or more, all because of mental accounting. Your mind has separated that $1,000 windfall from the money you spend on your credit card bill every month. While we always encourage saving where you can, sometimes it might make more sense to pay off a high-interest-rate credit card bill first. 

Making mental accounting work for you

The good news is, there are ways to make mental accounting work in your favor. For example, it might help to think of separate savings buckets for current expenses, emergency savings, retirement savings and college savings for your children. Then if your car needs repairs, you’re not likely to dip into retirement savings if you already have a dedicated bucket of money for current expenses or emergency savings. 

You might actually have different financial accounts, not just mental accounts, for those different buckets. If you don’t have separate financial accounts for different buckets, then mental accounting can be a good way to protect your long-term goals from short-term needs or impulses. 

Take a critical look at your spending habits and identify any areas for improvement. Once you start to become more aware of how you might be using mental accounting, it gets easier to see ways you can redirect these unconscious behaviors. Being more mindful of how we assess the value of money can go a long way in helping us make choices that serve us better in the long run.