If you take an economics course at the Donald School of Business you will learn a lot about supply and demand, markets, perfect competition and monopolies.
All the theory underlying these concepts assumes that all of us, no matter how well informed, are rational.
In other words, we make choices based on searching out information, comparing costs and benefits, and coming to logical, rational conclusions about which option maximizes benefits over costs.
The problem with all that we know about economics is that we ultimately know we all make irrational decisions.
We see this more often than not when we use credit.
Behavioural finance, the application of psychology to financial and economic decisions, is a growing field of study that is being applied to the world of personal financial decisions.
Mental accounting is the notion that people mentally segment assets or accounts based on the intended use.
In the realm of personal credit management, people tend to segment (mentally account) different credit accounts based on the purpose or use of the items purchased.
For example, a number of years ago, I had clients that came to see me about a mortgage to fund a new home. They had a growing family and wanted to “move up.”
While completing the mortgage application, I discovered that they had two credit cards. One had a low annual rate of 10.9 per cent and the other a much higher regular rate of 19.9 per cent.
Both cards had relatively small balances that summed to a combined total of about $2,000. What I could not understand was why they didn’t combine the two balances into one card with a lower interest rate?
The answer was simple. One credit card account was used to cover vacation expenses — financed at 19.9 per cent; the other to cover costs for their kids school clothing — financed at 10.9 per cent.
Oddly enough, this was my first exposure to behavioral finance and the effects of mental accounting on customers’ financial plans. The customers were segmenting accounts based on their use, ignoring the total cost of borrowing.
Of course these customers, and many of their fellow consumers, would agree that it is common sense that combining these balances into one low rate card would save money. But common sense more often than not does not rule our financial choices.
Moreover, debts incurred for “enjoyment” (vacations) are usually not paid off as fast as debts incurred for future benefits, such as education.
What psychologists refer to as a cognitive bias takes over.
To my customers, the importance of the school clothing meant that they were willing to pay a lower interest rate (10.9 per cent) on the cost of funds to pay for the school clothing while sacrificing a higher cost of funds (19.9 per cent) on the less important vacation expenses.
The result was that their total cost of borrowing was much higher than it needed to be. Cognitive bias was negatively impacting their ability to meet their overall financial plan.
In other words, repayment of the debt that was taken on for pure pleasure — the vacation — was perceived by the customer as having a higher risk, and a greater feeling of guilt for having taken on the debt.
The result in most cases is debts related to enjoyment are not paid off as fast as debts incurred for long-term benefits. In this particular case, guilt was compounded by the higher interest rate paid on the card used to pay for the vacation.
So what are we as humans to do? Unfortunately, we are not always rational so we cannot depend on using a method comparing costs and benefits.
First, we need to accept that we are irrational, and that financial plans are not short-term in nature but rather long-term. Second, avoid the trap of mental accounting by using other lower-cost credit, or even better, cash. Third, build enjoyment into your financial plan by planning to pay for fun things using short-term savings vehicles, such as money market funds and cashable GICs.
Finally, remember, you are in control of your financial destiny.
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.