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The benefits of mental accounting

Chris Farrell Jan 6, 2011

Question: I received a $1,200 refund from my mortgage company due to excess funds in my escrow account, which I paid into over the last year. My question is this: since that money was originally budgeted to pay the mortgage, should I put that money to the principal or put it into savings? We are trying to grow our emergency fund to about $20,000 and we are just slightly more than half way there. Thoughts? Thanks! John, Morgan Hill, CA

Answer: Well, the quick answer is that you can’t go wrong. It’s a good use of the money to pay down the mortgage and it’s also a smart move to add to your emergency savings. I would recommend putting the $1,200 toward savings.

What’s more, your question illustrates a key insight of behavioral finance: The role of mental accounts.

Here’s how Meir Statman, a leading behavioral finance scholar at Santa Clara University and author of the recently published, What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions. (Statman’s book is terrific, well worth reading and thinking about. It’s an addition to book shelf.)

We often place monies in distinctly labeled “mental accounts” and treat them accordingly. Mental accounts resemble checking accounts, and money in our mental accounts resembles money in our checking accounts. Mental accounts help us keep track of our money and direct it to where we want it. We make sure that there are sufficient balances in each of our mental accounts just as we make sure that we have sufficient balances in each of our checking accounts, so checks we sign at the grocery store or send to electrical companies do not bounce.

The simplicity of mental accounting helps us to face two major life challenges. One is the challenge of dividing our spending, saving, and investing between the present and the future. How much shall we spend, save, and invest during our working years and how much in retirement? The other is the challenge of dividing today’s spending among all we want today. How much shall we spend on groceries and how much on movies? How much on rent and how much on travel?

In a sense, you have two mental accounts in conflict. You have a real estate account. Since the unexpected money comes from your actual real estate account you feel it should stay there. Yet you also have a savings account and a goal for it. The thing is, the $1,200 will allow you to take a big step toward your savings goal. The impact is greater than putting it toward the mortgage.

That’s why I would “transfer” the money from real estate to savings.

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