March 20, 2017

Why our brains make stupid money choices

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We often blow budgets while on vacation because we want to relax and not stress over every purchase. And foreign currency can seem like play money.

Money is money, whether it's cash in our hands, plastic cards at checkout counters or encrypted bits of data coursing between computers on the internet.

But our brains don't view all money as equal, thanks to what behavioral economists call “cognitive biases”:

• We spend cash more carefully than plastic.

• We regard tax refunds as a windfall rather than a return of what we earned.

• We'd rather have money now than more money later.

Sometimes our illusions about money can be harnessed for good. The “Save More Tomorrow” program, created by economists Richard H. Thaler and Shlomo Benartzi, has people commit to increasing their retirement contributions starting one year in the future. In the economists' initial study, workers who agreed to save future dollars nearly quadrupled their savings rate in four years.

Too often, though, our money illusions work against us. When we treat some forms of money as less real than others, it can really cost us. For example:

FINANCING FUN

Time-shares and recreational vehicles often are pitched as a way to save on future vacations. Anyone who has owned either knows that's not necessarily true. First-time RV buyers, for example, often underestimate the costs of maintaining, repairing and fueling their rigs. Time-share newbies can be gobsmacked by rising annual fees, the hassles of trading their units and the difficulty of shedding unwanted time-shares.

The math really turns sour when either purchase is financed.

Developer financing for time-shares typically carries interest rates of 15 percent or more. RV loan rates can be lower, but loans can stretch 10 to 20 years, inflating the cost of the purchase by 20 percent to 50 percent.

You shouldn't borrow money to finance luxuries, and that includes vacations. If you're determined to buy, pay cash for secondhand versions.

A brand-new 2017 Fleetwood Storm RV costs six figures; we picked up a 1998 model with less than 7,500 miles on it a few years ago for $15,000. Similarly, “used” time-shares sell on the secondary market for as little as a penny, although higher-end locations may cost a few thousand dollars, versus an average of $22,240 for a time-share bought “retail.”

ON VACATION

We loosen the purse strings while on vacation because we want to relax and not stress over every purchase. As a result, six out of 10 people overspend their summer vacation budgets, according to a survey last year for Citi ThankYou Premier Card. Add in confusion about exchange rates, and it can feel like the foreign currency in your hand is just play money.

Ways to keep it real: Check exchange rates before you leave, so you have a general idea of what your dollars should be worth, then use a calculator or a currency exchange app to check prices on the fly.

HEALTH CARE COSTS

High-deductible insurance plans are supposed to make us more careful about our health care spending, because we have to shell out more of our own money before insurance takes over.

It's hard to be careful, though, when it's difficult or impossible to predict what that care will ultimately cost. Medical providers charge wildly different amounts for the same treatments, and what they charge may be wildly different from what they'll actually accept. (Witness the recent $16,800 bill we got for a colonoscopy that insurance finally settled, in full, for $350.) What high-deductible plans can do is cause people to put off seeing the doctor, which ultimately can result in much bigger bills for treatment.

All kinds of brain fails are to blame for this: status quo bias (we want to keep the money in our pockets), loss aversion (it can be painful to reduce our lifestyle, or spend less on stuff we want, because of health care costs) and hyperbolic discounting — the benefit of keeping our cash seems much greater than the possible future benefit of good health.

The solution is to use mental accounting, another thinking flaw, to your advantage. If you opt for a high-deductible plan, make sure that you keep enough cash earmarked in savings to cover that deductible and that you use it to stay current on your health care.

We may not be able to change the ways our brains are wired, but we don't have to let that wiring cause us to make stupid decisions about money.

Liz Weston is a certified financial planner and columnist at NerdWallet. Email: lweston@nerdwallet.com . Twitter: @lizweston.