‘Mental accounting’ is the idea that we create imaginary money accounts in our minds. The money within these accounts is treated differently and can affect our spending and saving habits.
A relatively new concept, most of us probably haven’t heard of mental accounting, but by learning about it, we can spend, save and grow our money more effectively.
What is mental accounting?
When we are mental accounting, we treat some of our pounds differently to other pounds and place them into different pots in our minds. We may categorise them by entertainment, holidays, clothing, weekly shop, and so on.
When we spend from each, we make a mental note of which pot the money came out of.
By doing this, we often allow ourselves to pay more for things, justifying that the money is from a pot we can spend more from, such as holidays, rather than our salary, which we can view differently.
For example, think of an expensive £50 meal – £100 for two – you may have paid for on a trip away.
You may not pay £50 for a meal in your local restaurant on a Saturday night, but by filing the expensive meal in the ‘holiday’ mental account in your head we treat it differently.
However, money is the same, wherever it sits.
How else do we mentally account our finances?
The source of where the money comes from can also play a part - for example, money you may have inherited or received from a tax rebate.
If you were given £1,000, you might spend £500 on new clothes in one go, but you probably wouldn’t spend this amount of our salary on clothes in a given month.
Instead, it can be a good idea to think about how you could put this money towards something you’re saving for, or perhaps pay off money you owe on a credit card or loan.
Using it to your advantage
Although splitting your money into different pots can encourage us to spend more on certain things, it can also be used to your advantage when it comes to budgeting. For example, you could allocate a certain amount of money to each pot each month.
Accounts like Monzo and Starling allow you set up multiple digital pots, so it’s easy to see how much you’re allocating, spending and saving in each category. For example, you may want to set up a pot for all of your bills, another for eating out or socialising, and other pots for particular saving goal – like a holiday, car or just a rainy day.
This idea of ‘piggy-banking’ means you can keep track and better manage your finances. It’s a better way to budget than mental accounting where the pot may become bottomless if you’re not keeping an eye on what you’re actually spending.
However, don’t be afraid to make changes if you need to.
“The moment you tag purpose to a pot of money, it’s very difficult to get comfortable with spending it any other way,” says Peter Brooks, head of behavioural finance at Barclays. “It can be emotionally painful.”
This can be to such an extent, some people simply won’t shift money around at all, he warns. “A pound is still a pound. No one is stopping you from moving it around. Only yourself.”
If you still have money left in a pot for socialising at the end of the month, but you’re struggling to pay of your credit card, it makes financial sense to pay off the credit card rather than spending the money on an expensive meal. Make sure your pots are flexible if you need them to be.
Top budgeting tips
- If the idea of multiple pots or accounts is confusing you, stick to one and arrange all direct debits to go out on the day after you’re paid, suggests Holly Andrews of Kis Finance. “This means that a day or so after being paid, all the money left is your spending money and you just need to make sure you budget for food and travel expenses to ensure you don't run out before next pay day.”
- If you have money in various spending pots, think about using this money to pay off money you owe on credit cards or store cards which are incurring interest and actually costing you.
- Treat all money as equal, no matter where you inherited it from. Think about how you’d normally spend the money and whether it’s worth saving for something you know you’ll need to pay for in the future.
- Before impulse buying with a credit card, ask yourself whether you need it and whether you can afford it. Martin Lewis from MoneySavingExpert has a free money mantras card which you can print off and keep in your purse or wallet, to ask yourself whether you should be spending the cash.
- If money is tight, there are ways you can prioritise with a budget plan. It helps us to anticipate the bigger things like a holiday so you save the money upfront. Our article can help you set a budget.
- Give your bank balance a boost by finding a new energy deal or switching to a better car insurance deal at renewal time.
- By understanding your unconscious biases and accepting them, they will be easy to tackle. Many of our biases influence our decision making and lead us to make the wrong decisions, including our personal finances. Our article on overcoming money biases and blind spots could help you become financially stronger.