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‘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.
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.
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.
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.
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