FOOL ON THE HILL
Many people use mental accounting: They treat some money (such as gambling winnings or an unexpected bonus) differently than other money. When deciding how to use your tax rebate, you may learn whether you use mental accounting to your advantage or disadvantage. Once you've got that under control, we have some suggestions for how you might use that money wisely.
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Investors, 'fess up: When your tax rebates comes, which of the following will you be? Rational Ron: "I plan to use this $300 just as I would any other money in my budget. I have an extra $300 on my credit card this month, so I'll pay that down first." La la la. Las Vegas Lou: "Whaddya mean? It's found money! Yippee! Spend, spend, spend!" Or, "Hey, it's mad money, perfect for that risky stock the spousal unit says I can't buy!" Be honest: Are you like Lou? That's a perfect example of "mental accounting," or the tendency to consider some dollars to be different from others. It drives traditional economists crazy, because they believe dollars are fungible, no one different from any other, and that people are Rational Ron, treating all of them the same. But behavioral economists have found that most people will think the tax rebate is found money, apart from one's budget and a person's normal saving and investing. In the book Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich point out that people who use mental accounting tend to splurge with their tax rebates, spend more with credit cards than they would if using cash, and maintain both savings account and credit card balances. They also think they're not reckless spenders, but have trouble saving. They provide two tests for whether you use mental accounting to your disadvantage: You have no emergency or nonretirement savings, and you carry month-to-month credit card balances. How to remedy this? One way is to use the same technique that's causing you problems. Mental accounting can be good. For example, I don't consider my 401(k) contribution to be my money. It's deducted from my paycheck and I never see it, so I separate it mentally and never think of the contribution as money I can tap for other purposes.
If you have an emergency expense, by all means, use the rebates. But if you are fortunate enough not to, here's where you might find it best to put the money: Pay off some credit card debt. By the way, $300 in credit card debt at an 18% annual interest rate is $54 a year in interest alone (I'm using simple interest, not each month's rate compounded, which is probably even more). If you make minimum payments of 1.5% to 2.5% of that $300, it will take from now until doomsday to pay off the balance. I've read many figures on the subject, but if you average them, they seem to agree that individual Americans have about $4,000 in credit card debt, households anywhere from $5,000 to $7,000. At an interest rate of 18%, if you pay off that $300 in debt now, it's as if you earn $54 a year. If you pay down $600, it's as if you receive an annuity of $108 each year. If you're investing in stocks and don't pay off your credit cards in full every month -- I'm not talking about a month here or there at super-low introductory rates -- bud, you've got your wires crossed. Start or add to your rainy-day fund. And if you have an emergency, you don't have to sell your stocks. In fact, if you don't have a rainy-day fund, what are you doing investing any money not in your employer-sponsored 401(k) or your IRA in stocks anyway? We strongly advise not investing in stocks any money you might need in three to five years --preferably five or more. My view is that the house is something I don't want to tinker with. I'm hoping that someday we can sell it when we retire and move into something smaller (a condo on the beach, a shack in the mountains, a pied-a-terre in Paris...) without having a mortgage. I don't like the idea of tapping into that for anything other than short-term purposes, and even if a home equity line today has a lower interest rate than a credit card, it can lead you down a slippery slope into a debt trap. Home equity lines also usually have a fluctuating interest rate, and can jump as interest rates increase, as they inevitably do after a period of decline. Finally, if you have paid off your debt and have a pretty good rainy-day fund, now you're in the position to be thinking about stocks. If you're a newcomer, you can begin buying stock with $300 or $600 easily. Consider starting a DRIP investing account, or buying a total market stock index fund, SPDRs (AMEX: SPY), or a new brand of the same, iShares (AMEX: IVV). If you're a more experienced investor, now may be the time to reap significant long-term rewards by putting that rebate check into sound stocks whose values may have been hit by the bear market. In fact, if you do regular investing -- say monthly or quarterly -- why not consider the tax refund to be part of your next regular purchase? But isn't consumption good for the economy? Frankly, I don't give two hoots if paying down your credit card debt means you're not buying another pair of AirJacobs. If there is a danger to the economy from too much consumer debt, failing to pay off any of it now only puts off the pain until later -- and adds interest to it. Don't believe anyone who says otherwise. They're short-term thinkers, and you want better associates. If you actually save the money -- perhaps through a rainy-day fund invested in a money market account -- you add to the pool of savings available for a bank or other institution to lend. This may help the economy. If you buy stock, you add to your own future ability to pay your own way and, yes, consume. That will help the economy. Even if you have a zillion-dollar portfolio and think you're all set for life, take a moment before you spend that rebate check, and look over your financial house. And if you're like most people, doing your best to take care of yourself and loved ones, and plan for the future, that check can make a difference. Tom Jacobs's (TMF Tom9) rebate hasn't come yet, so he doesn't have to walk the walk. To see his stock holdings (and run screaming), view his profile, and check out The Motley Fool's disclosure policy.
In EZ Solutions for Your Debt!!!, Motley Fool writer Paul Commins mixes sidesplitting humor with solid help for your debt situation. People earn the equivalent of Olympic medals every day for taking control of their debt loads and getting their financial lives in shape. You can, too. Once you read Paul, you'll see why.
A little over a year ago, after my 44th birthday, I was able to establish a rainy-day fund of over six months' livings expenses, invested in an interest-bearing savings account. (Now I'm checking out our Short-Term Savings Center for better options.) I always knew I should have one. But before I'd only had a month or two at best, and it always felt as if I were living on the edge. The joy of a larger fund is that if you lost your job, you wouldn't have to go into debt during your job search. Some people fortunate enough to have a home equity line of credit on their houses may feel secure knowing they can use that as a credit card, but with lower interest rates, for extraordinary expenses.
The media and politicians with tacit acceptance seem to trumpet the American consumer as the savior of the economy from a terrible, deep recession. Balderdash. If you have purchases you need to make, by all means, you know best. But if you have a budget, and are sticking to it, this is a chance to make some sound decisions.
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