Last week, we introduced the concept of mental accounting. We want to continue the theme this week as part of our ‘behavioural economics month.’
Mental accounting can be seen every day with little expenditures like gift vouchers. However, sometimes people apply mental accounting to much bigger parts of their financial management. And that is where it can get expensive.
To recap, mental accounting is a common mistake people make with their money. When people apply mental accounting, they dedicate specific money to a specific purpose – ignoring the fact that money can be applied in many different situations.
A common situation that financial advisers come across is where people inherit money. They often wish to keep that money separate from their other finances. A common approach is for adult beneficiaries who also have children to want to keep ‘grandma’s money’ separate from all their other money. The idea is that Grandma’s money will go to Grandma’s grandkids when they (grandma’s kids) die themselves
While we like the sentiment, it’s often not the best use of money. After all, when people die their estate is generally realized – that is, most or all of the assets are converted to cash and the cash is put into one large pool. Because it all ends up as cash, it does not matter how the asset was held prior to the estate being realised. So, our advice to people who receive an inheritance is typically to include that money amongst the rest of their wealth and do everything they can to make it grow further. After all, maximising wealth is actually the best way of maximising their kids’ eventual inheritance.
Alternatively, if our clients really don’t need Grandma’s money, it can often be a good idea to pass it on to their kids now and help them do something sensible like buy their first home.
People also often apply mental accounting when it comes to debt. Many people simultaneously have a debt and some money in a savings account. Typically, the debt will be incurring much higher interest rates than the person earns on the amount held in their savings account. So, if the savings were used to reduce the debt, the client would be better off.
Lenders have cottoned on to this, and many make an ‘offset savings account’ available to their borrowers. You may have heard of such an account: it links your savings account to your loan, such that interest is only charged on the difference between the loan amount and the savings amount.
For example, if you owe $100,000 on your loan and have $50,000 in an offset savings account, the bank will only charge interest on $50,000. This is the difference between your debt and your savings. Effectively, this lets you repay the loan while retaining the flexibility to ‘redraw’ your savings and use them for some other purpose. Offset accounts can be wonderful financial planning devices.
This brings us to one final example of mental accounting. Whenever you have debt, every dollar you spend is borrowed. This is because you could have dedicated that dollar to repaying your loan.
For example, let’s say you owe $100,000 on your mortgage. Now let’s say that your boss gives you a $5000 bonus that you weren’t expecting. You decide to use that money to buy a holiday. Most people would not think that they have borrowed money for the holiday. The boss gave them cash and they used the cash to buy a holiday. But, again, this is a trick of mental accounting. The reality is that had they not taken the holiday, but instead repaid some debt, the debt would now only be $95,000.
Had they not gone on the holiday, they would have less debt. Effectively, they have borrowed the price of the holiday.
This happens because money is fungible: a dollar can be used for anything that can be bought using a dollar. The same dollar can be used to pay for a holiday or to retire debt.
Now, we don’t want to sound like party poopers! Holidays are fun and people need them. But if you have debt, it often pays to avoid mental accounting. That way, you will know the true cost of every purchase you make.