In my Yahoo!Finance column that posts on May 15, I discuss the concept of mental accounting – the way people separate different pools of money in their heads in ways that are both rational and irrational. For instance, you wouldn’t withdraw funds from your child’s 529 college savings plan to pay for orthodontia, because you’d pay that out of “current assets” rather than “future assets.” 

It’s worth noting that the use of credit cards tends to obliterate good mental accounting. Behavioral economists find people pay less attention when purchases are “decoupled” from payment.  

Let’s say you buy a $50 jacket on a credit card. “Compare the impact of paying $50 in cash at the store to that of adding a $50 item to an $843 bill,” writes Richard Thaler, professor of behavioral science and economics at the University of Chicago business school. “Psychophysics implies that the $50 will appear larger by itself than in the context of a much larger bill, and in addition when the bill contains many items each one will lose salience. The effect becomes even stronger if the bill is not paid in full immediately.” 

One study found that college students leaving the campus bookstore who paid cash more accurately recalled the price they paid than students who used credit cards. A separate study found graduate students who were allowed to bid on items in an auction with a credit card bid up to 100 percent more than those restricted to cash payment. So if you’re having trouble reining in your spending, cut up the cards and pay cash.  

• Credit Card Chaos From Banks You Bailed Out
• Credit Card Pullback
• Reader Qs on Credit and Debt
• Reader Question on Credit Cards
• Fed Limits Credit Card Fees

This entry was posted on Wednesday, May 14th, 2008 at 2:34 pm and is filed under credit cards, mental accounting, spending. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.