We all need money, but there are degrees of desperation.
How many times has Christmas rolled around and seemingly sneaked up on you, catching you unawares, and unprepared for the present-buying season? Rather than disappoint the kids by telling them some story involving Rudolph and two drunk hunters, you tap into the emergency fund, justifying this by saying that it’s only one time, and if the kids don’t get presents, then it will truly be an emergency. Or, worse yet, you tell yourself, correctly, that it’s not really an emergency, and you whip out the credit cards instead, promising to yourself to have them paid off by March, or June, or next Christmas.
It’s not just Christmas that is the trigger for these reactions. It could be a vacation, the insurance payment that comes every six months, property taxes, replacing the worn out carpet, and on and on. All of these payments are ones that you know that you’re going to have to make eventually, but instead of preparing for them, you find yourself scrambling when they happen to find the money to pay for them.
What’s happening here? Why are we always surprised when Christmas comes?
What is happening is that there is a battle going on inside your mind. In one corner, you have your rational, thinking self, powered by the prefrontal cortex. It’s the part of your brain which makes you engage in responsible adult behavior, like living within your means and setting aside money for a rainy day and for retirement investing. It also makes you choose broccoli over chocolate cake at dinner.
There’s another part of the brain called the limbic system, or, as I like to call it, Monkey Brain. Monkey Brain served us well back in the good old days when we were hunting mammoths and didn’t know how to farm, as it honed our survival instincts. It treated everything as if there were no tomorrow because, usually, chances weren’t fantastic that there would be a tomorrow.
However, Monkey Brain never adapted to today’s realities, so now, he continues to tell you to seize the day, for tomorrow we die, when that’s very unlikely to happen. He works in the subconscious, so Monkey Brain’s thoughts and desires often come out as psychological biases.
Rational, thinking you knows that there are other bills that have to be paid which don’t always show up in the monthly budget, such as Christmas. Monkey Brain doesn’t want to set aside money for Christmas because Christmas is such…a…long…time from now, and he’d rather you go out and buy the 183” flat screen TV right now so that you can start enjoying the man cave as soon as you can get that TV installed.
To convince you to spend now and not save for later, you get exposed to two psychological effects. The first is called hyperbolic discounting, which means that we tend to discount future pleasure in exchange for pleasure right now. If asked which they’d prefer, $100 now or $110 in a year, many people will say $100 now because, hey, it’s now! That’s hyperbolic discounting in action.
The second effect is called mental accounting. Mental accounting simply means that you, in your head, put different money into different buckets rather than visualizing all of your money as being one single chunk. To prevent you from filling up the “save for later” bucket, Monkey Brain will come up with as many “needs” (by convincing you that many of your “wants” are actually “needs”) as he can which have to be taken care of now.
Thus, even though you know that Christmas comes around every year, Monkey Brain assaults you with different psychological attacks to convince you that you don’t need to save now for Christmas, which is several months down the road.
How do you convince Monkey Brain to save for Christmas?
The best way to make sure that you’re setting aside money for your irregular but recurring expenses, such as Christmas, vacation, a car replacement, insurance payments, health care deductibles, and the like, is to hide money from yourself.
Hide money? Am I telling you to go stuff money in a mattress?
Not exactly. Plus, if you did that and the house burned down, good luck convincing the insurance adjustor that you had a few C notes stashed away in the box springs.
Instead, what we do is set up a separate account for setting aside that money. It’s different from the account where you get your paychecks deposited into. Theoretically, it should be more difficult to access money from this account so that you don’t go spend it in a wild bender of a shopping spree, so, depending on how much self-control you have, this could mean going to another bank for this account.
Here’s what I look for in a good side account:
- Free checking. You shouldn’t pay a fee for this account. You don’t want to give the bank money every month just to hide money from yourself.
- No minimum balance requirement. There is an opportunity cost to storing that money somewhere, because it could be used in investing and saving, so you don’t want to lock up even more money. Now, we do keep more in the account than is necessary in case I have a case of Monkey Brain playing with the calculator and miscalculate, but we don’t keep too much buffer in there.
- Free bill pay and unlimited number of transfers. This is crucial for a reason I’ll explain in a minute.
- Clean, concise, easy to use online system. You’ll be transferring money in and out of this account, so you want to make sure that the website is easy to navigate lest you send the wrong amount of money to the wrong place.
Why did I make the case for the free bill pay and unlimited number of transfers? It has to do with mental accounting.
According to recent research from a team led by the University of Utah’s Himanshu Mishra, people who make payments from a single account spend less than people who spend from multiple accounts. It’s because we can’t keep track of all of our spending and tend to assign different categories to different accounts. The fuzzier the math becomes, the easier it is for Monkey Brain to slip in unwanted purchases.
If you’re eligible for USAA membership and have the discipline to keep the accounts straight even though they’re at the same bank, then it’s easy enough to set up two accounts with them, and then, when you need to make a one-time purchase, transfer the money from the side account to the main spending account. The key is to make sure that ALL of your bills are paid from the same account and that ALL of your spending comes from the same account. According to the University of Utah research, this could mean you wind up spending 10% less than you otherwise would.
How do you know how much to set aside?
I think the easiest way to get in the right ballpark for how much you need to save is to use what you’ve spent in the past 12 months. You can find out how much you spent on vacations, on Christmas, and the like, and that’s a pretty decent starting point. You may find that you spent a lot more than you expected to, so the review is a pretty good practice regardless.
There are some items which may require a little more guesswork and cushion. A good example is a replacement car. Let’s say that you have a ten year old car. It’ll probably go in the next five years, but it might last another ten. Who knows? You know that your budget for a replacement car will be $15,000. Given that you expect to replace the car in five years, that is sixty month timeframe for buying the replacement car. $15,000 divided by 60 months is $250 a month.
However, you’re keeping multiple “side accounts” in one actual account. How do you keep track?
We transfer the total amount over each month and then log the side accounts on the same spreadsheet we use for our budget. That way, we keep a running tally of how much we’ve set aside for all of our different categories. Our list includes:
- Home insurance
- Auto insurance
- Christmas and birthday gifts
- Auto maintenance
- Property tax
- Healthcare deductibles
- Car replacement
- Annual gym membership
Then, when the time for the payment for something in one of these categories comes around, we simply transfer the money and make the payment. Voila. By setting aside a little money each month, we’re keeping ourselves from having to dip into emergency savings when these items come, protecting our emergency funds for true emergencies.
This process will take a couple of months to get used to. You’ll probably think that there’s money missing and you’ll feel tight. However, due to another psychological process called hedonic adaptation, you’ll get used to the new budget and the new spending patterns, and, in the future, you’ll go through a lot less stress when the bigger bills come.
Christmas comes once a year. From now on, you’ll be ready for it!