This post expands further on the conversation in the video about keeping money in different boxes, or buckets. Like us, many financial planners recommend that you have a) an emergency fund of upto 6 months of expenses; b) a school fund for your children; c) a savings fund for assets like houses; d) a trading account for playing the market; e) money put aside for retirement; and so on. This is a reasonable way to organize your financial life and as Monika mentions, many have been surprised at how well this has worked.
I do this too in my personal life. I am somewhat of a spendthrift. So, when my salary goes into a bank account, portions of it are automatically directed into different buckets like those above. What is left in the account I spend cheerfully, my goals for the month being met upfront.
But this post is to caution you about some behaviors that can quietly creep in. This is known as mental accounting bias and it works this way. Once we put money into different buckets, baskets, accounts, we tend to treat them differently. An example should help make my point.
Let us say for instance that you have been putting money aside towards investment but until you do you some homework you are not ready to enter into a systematic investment plan (SIP) or a mutual fund. So, it is in a savings account earning 4%. A credit card bill comes along, which charges a much higher rate for continuing to borrow that money. Its payment should be made from your spending account, but that is depleted because the credit card purchase was for an impulse buy that you couldn’t really afford. You may resolve not to give into that impulse in a future, this is also part of your discipline in the financial planning process. But at the moment, with the spending account mostly gone, would you dip into the investment account to pay off the credit card bill? And should you?
Think about it for a moment. The money marked for investment is earning 4% and the credit card loan is about 11% (or more). Some of us might consider the investment account untouchable and make the minimum credit card payment (effectively borrowing at 11%). You swear to pay it off from your spending account of the next month. What if instead of an investment account, the other account you could tap was one earmarked for your child’s education? You would be even less likely to raid it to pay off that credit card bill and compound your guilt? So, you make the financially unsound choice to pay 11% interest when you don’t have to. My point is that we tend to do these irrational things, because we forget one thing- that money is the same no matter which account it is in. In other words, money is fungible.
Ever the optimist, I do think it quite possible that, a one-time tapping into that investment account or education account to pay off the credit card may actually help you resist those future impulse credit card buys !