11.29.2008

From quirky mental accounting to real-income living

The Challenge of Living Within One’s Means

Excerpt:

...the shift to real-income living demands not only new spending habits, but also a wholly different way of thinking about money.

“Every time we ended up overextended, we used to refinance our house,” Ms. Jones, a software engineer in Scotts Valley, Calif., acknowledged. “The house would creep up in value, and every five years or so we’d take out another $50,000, and pay off whatever we needed to.”

She and her husband never felt that they were getting into debt, Ms. Jones said, because a kind of magical thinking prevailed: “You owed more, but then your house was worth more,” she said. “So you didn’t really have debt because you could always sell your house — and poof! — all previous sins would be erased.”

For years, the Joneses sensed that something was wrong. Their expenses kept spiraling out of control and their checking account was chronically overdrawn. But as the economy began to tremble — and the couple realized that they wanted to right their finances before their 11-year-old daughter entered college — they decided to change course. “There was this constant, underlying anxiety about money,” Ms. Jones said. “It was ridiculous — I knew we should be able to live on what we were earning.”

But switching to a lifestyle based on your actual income is more challenging than it seems, especially if you’ve been relying on credit as an income supplement. The maxim to “tighten your belt” implies that self-discipline is the solution, but our financial brains aren’t so easily tamed.

Many people rely on a quirky system of mental accounting when making financial choices, according to economists who study spending. If you saved $30 when buying a sweater, for example, you might talk yourself into buying shoes, with the rationale that you have an extra $30.

The use of credit tends to make people’s financial reasoning even more flawed, according to Dilip Soman, a professor of marketing at the Rotman School of Management, University of Toronto. “I find that people who are used to paying for expenses by credit card tend to create an ad hoc ‘credit card bill’ mental account,” Professor Soman said in an e-mail message.

“If the credit account vanishes, people are now forced to make cuts into their lifestyle, because their budgeted spending money supply has now shrunk,” he said, even though that supply shouldn’t have been included in their accounting from the start.


Comment: Something my parent's generation did naturally - "real-income living"

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