How Do Behavioral Finance Concepts Relate to Budgeting?

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The concept of behavioral finance that most relates to budgeting is mental accounting, which is separating your money into separate accounts.  Doing a budget is mental accounting, because you are separating your money into different accounts where your money is intended to go.  You could also give savings account a specific purpose.

It is also possible to do mental accounting by the source of the money.  For example, people often treat tax returns as “found money”.  I worked part-time doing tax preparation last tax season.  There were people who were willing to borrow money at high rates to pay their fees because they viewed their tax refund as being “found money”.

This can lead to irrational behavior when you have high credit card debt or high interest loans.  If you have high interest rates, it is rational to pay off your debts as quickly as possible.  People may have a tendency to keep a college fund due to an emotional attachment, when it isn’t rational to do so.

I’m trying to examine my own behavior and see if I have been guilty of irrational mental accounting.  I owe our savings about $14,200 for my MBA.  At the same time, we have a large entertainment budget.  The reason we don’t cut our entertainment budget to pay off my MBA is because I promised to pay for it myself when I discussed going back for my MBA with my wife five years ago.  I plan to pay it back by using my unspent personal and clothing budget and by working part-time, beginning in 2016.

We have been guilty of treating money differently depending on its source.  We had years when any money we earned above our regular contract was ours to do with as we choose.  For several years, I set aside my coaching pay for a family vacation.  I don’t think that we were irrational in doing this, since we haven’t really had any unpaid credit card balances since our first year of marriage.

We are flexible in using our monthly budget accounts.  We will, for example, take money out of our entertainment account, if the food budget is short.

It is possible to argue that you should spend no money on entertainment when you have high interest debt.  However, if you feel too deprived, you are likely to give up in frustration.  If you have high interest debt, you should probably use your tax refund to pay it off.

It’s easy to rationalize your mental accounting when it isn’t rational.  I’ve joked that, “it’s easy to rationalize, because everyone else does.”  Thirty-four percent of American households carry credit card debt from month to month.  Those households carry an average credit card debt of $15,706.  If you have credit card balances, you need to quit digging a hole, eliminate unnecessary spending, and considering using all sources of your income to pay off your debt.

Coming Up

Next week I plan to blog out funding college or technical school.

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