In our last blog we talked about mental accounting – how we separate our money into buckets in our minds. If we were all completely rational about it, generally speaking we would look at what we earn on our savings, what we pay on our debt, how our taxes are affected, and pay off our most expensive debt as the number one priority. Why? Because at the end of the day, your assets are your assets, wherever they are. And you want to maximize your savings by decreasing what you pay to anyone else. But...
Your Brain Gets in the Way
Here's the tricky part. Let’s say that you have credit card balances. Credit card interest is one of the highest interest rates out there. If you set aside an emergency fund, but keep credit card balances, it’s probably costing you money. You should pay off your credit cards. But can you control your credit card spending? Do you feel flush with cash when your credit card balance is zero? So if you pay off your credit cards by fully depleting your emergency account, will you just rack up more debt you can’t pay off on your credit card? And, have no emergency fund?
1) In theory, you can use your credit card in an emergency. Rule of thumb suggests your emergency fund should be at least 3 months of expenses. Does your credit card allow for that? If not, you probably need savings.
2) If you commit to pay off your credit card debt regularly, then it might be smart to use a savings bucket like your vacation or emergency fund to get control of your credit card debt. Then begin saving for that emergency fund or vacation.
3) If you can’t manage your credit card debt, is mental accounting for you? If you let credit card debt hang over your head will it make you feel guilty so that you charge less? Meanwhile, set savings aside so you don’t add your next vacation expense to your existing credit card debt. Just know that it is costing you money to manage your own behaviors. And seek money management assistance.
Is the last approach rational or advisable? Not really. But we aren’t rational. Sometimes we just need to know how we think, understand our weaknesses, and mentally manage ourselves.
Carrie Rattle is a Principal at BehavioralCents.com, a web site for women focused on the mind and money behaviors. She has worked in the financial services industry for 20+ years and hopes to inspire women to better prepare themselves for financial independence. Thoughts always welcome: email@example.com.