Businesses, governments, and even churches use accounting systems to track, separate, and categorize the flow of money. People, on the other hand, use a mental accounting system. Imagine that your brain uses a mental accounting system similar to a file cabinet. Each decision, action, and/or outcome is placed in a separate file folder in the file cabinet. The folder contains the costs and benefits associated with a particular decision.

Once an outcome is assigned to a mental folder, it is dif­ficult to view that outcome in any other way. The ramifica­tions of mental accounting are that it influences your decisions in unexpected ways.

Consider the following example:

Mr. and Mrs. Johnson have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 10% in a money market account. They just bought a new car for $11,000 which they financed with a three-year car loan at 15%.1

This is a common situation. People have money in savings that earns a low rate of return and yet borrow money at a high interest rate, thus losing money. Mr. and Mrs. Johnson have their vacation home savings earning a 10% rate. Imagine how excited they would be if they found a safe investment earning 15%! But when the 15% opportunity came up, they probably didn't even consider it. If they would have borrowed the $11,000 from their own savings (instead of the bank) and paid themselves a 15% interest rate, the vacation home savings would be over $1,000 higher at the end of the three years.

Money does not come with labels. People put labels on it—there is dirty money, easy money, cheap money, and on and on. Mr. and Mrs. Johnson labeled their savings as "vaca­tion home" in a mental account. Although mixing the "new car" mental account with the "vacation home" account would have maximized their wealth, Mr. and Mrs. Johnson didn't do it.

MENTAL BUDGETING

People use financial budgets both to keep track of and to control their spending. The brain uses mental budgets to associate the bene­fits of consumption with the costs in each mental account. Consider the pain (or costs) associated with the purchase of goods and ser­vices to be similar to that of the pain of financial losses. Similarly, the joy (or benefits) of consuming the goods and services is like the joy of financial gains. Mental budgeting matches the emotional pain to the emotional joy.

Matching Costs to Benefits

People usually prefer a pay-as-you-go payment system because it provides a tight match between the costs and benefits of the pur­chase. However, things get more complicated when the pay-as-you-go system is not available.

We will look at three questions and how they were answered to illustrate the importance of the timing of payments. Ninety-one vis­itors to the Phipps Conservatory in Pittsburgh were asked these questions.2

Imagine that, six months from now, you are planning to pur­chase a clothes washer and dryer for your new residence. The two machines together will cost $1,200. You have two options for financing the washer/dryer:

A.   Six monthly payments of $200 each during the six months
before the washer and dryer arrive.

B.   Six monthly payments of $200 each during the six months
beginning after the washer and dryer arrive.

Which option would you choose? Note that the total cost is the same in both options, and that only the timing of the costs is different. Of the 91 people, 84% responded that they preferred the postponed pay­ment option B. This is consistent with the cost/benefit matching of mental budgeting. The benefits of the washer and dryer will be used for a period (hopefully years) after their purchase. Paying the cost over a concurrent period matches the cost to the benefit. Note that option B is also consistent with traditional economics; that is, people should choose B because it allows borrowing at a 0% interest rate.

The next two examples are not consistent with traditional eco­nomics. In the next two questions, respondents did not select the wealth-maximizing option. Consider this example:

Imagine that you are planning a one-week vacation to the Caribbean, six months from now. The vacation will cost $1,200. You have two options for financing the vacation:

A.   Six monthly payments of $200 each during the six months
before the vacation.

B.   Six monthly payments of $200 each during the six months
beginning after you return.

Notice that the payment options are the same as the prior question: six payments before or six payments after the purchase. The differ­ence is that the item being purchased has changed. The main differ­ence is that the benefits of a vacation purchase will be consumed in a short time whereas the benefits of the washer and dryer will be con­sumed over years. Which payment option would you choose for the vacation?

Sixty percent of the respondents selected option A, the prepaid vacation. In this case, the payment options do not match the con­sumption of the vacation. The benefits of a vacation are consumed during the vacation. But this vacation must be paid for either before or afterwards.

Traditional economics predicts that people will prefer option B because it is cheaper after considering the interest-free loan. However, most people choose option A. Why? People believe that a prepaid vacation is more pleasurable than one that must be paid for later. The vacation is more pleasurable because the pain of payment is over. If payment is to be made later, the benefits of the vacation are diminished by wondering, "How much is this pleasure costing me?"

An important factor in the decision to prepay or finance is the amount of pleasure expected to be generated by the purchase. The thought of paying for an item over the time that the item is being used reduces the pleasure of using that item. But let's face it, using a washer and dryer is not that much fun anyway. We might as well finance it. The dream home example at the beginning of this chapter is another matter. The pleasure of the dream home should not be tainted with debt and the thoughts of future payments. Therefore, Mr. and Mrs. Johnson are prepaying (saving for) the house.

The third question to the Phipps visitors was different in that it had to do with payments for overtime work. Visitors were asked how they would like to be paid for working a few hours on the weekends during the next six months—before they did the work or after? Prepayment for work to be done was not desirable. Sixty-six of the respondents preferred to get paid after doing the work instead of before. Again, this is not consistent with the traditional view of eco­nomics. The wealth-maximizing option is to get paid earlier, not later.

Aversion to Debt

In both the vacation and overtime questions in the previous section, people are expressing an aversion to debt when the good or service is quickly consumed. People seem to have a preference for matching the length of the payments to the length of time the good or service is used. For example, using debt to purchase homes, cars, TVs, etc., is popular because these items are consumed over many years. Using debt and paying off the purchase over time causes a strong match associated with the consumption of those items.

However, people do not like to make payments on a debt for a purchase that has already been consumed. Financing the vacation is undesirable because it imposes a long-term cost on a short-term benefit. This is also true for the third question. People do not want to get prepaid for work because it creates a long-term debt (working weekends for the next six months) for a short-term benefit (getting paid). People prefer to do the work first and then get paid.

This aversion to debt for consumed goods can also explain the surprising popularity of debit cards. Debit cards offer no advantage over credit cards. Credit cards can be paid off every month or the purchases can be carried over to the next month as debt. The card­holder has the option to use debt or not. On the other hand, the pur­chases on debit cards are paid automatically, like checks. The debit cardholder does not have a choice to use debt or not. The features of a debit card are a subset of the features of a credit card. So why the rapid growth of debit cards? The answer may be that debit cards eliminate the feeling of being in debt and, therefore, allow greater pleasure from the purchases.3