Investor Reforms - What’s New in 2009? (# 1)

Of late, every regulator be it RBI, SEBI, PFRDA or IRDA is trying to do his bit for the benefit of the common investor /consumer.

Following is the list of investor / consumer friendly reform measures announced by various regulators of financial services industry during the first half of 2009:

1. New Pension Scheme (NPS)—Better retirement planning (PFRDA)
2. Scrapping of Entry Loads in mutual funds —Lower transaction costs (SEBI)
3. Saving Bank Accounts—More interest earnings (RBI)
4. Health Mediclaim Insurance— Better renewal terms (IRDA)
5. Senior Citizen Health Insurance—Cheap and easy availability (IRDA)


New Pension Scheme (NPS)
New pension scheme (NPS) regulated by PFRDA is in existence since 2004 but was available only for government employees. Now, with effect from 1st May 2009, this scheme has been thrown open for all.

As ULIPs are considered better than the traditional insurance plans, similarly NPS (a defined contribution pension scheme) is an improvement over existing options for retirement planning such as pension plans of insurance companies, Employees’ Provident Fund scheme, Employees’ Pension Scheme, and Public Provident Fund (PPF).

What is the USP (Unique Selling Proposition) of the scheme? Potential to earn better returns (OPTION to invest in equities) at low cost AND truly long term since it is meant strictly for retirement planning.

Unlike your existing EPF, which is a mandatory, this one is optional and also not linked to your employer. So anybody can join in. Similar to ULIPs where various fund options exist, NPS offers you default option called auto choice life cycle fund, in addition to various other fund options.

However, the major drawback of the scheme is taxation of returns. Unlike, EPF or PPF, in case of NPS the amount at maturity is taxable. Let’s hope that this major irritant will also be removed as PFRDA is trying to convince the government to remove it. Just wait for the upcoming budget.



No more Entry Loads in Mutual Funds
SEBI has been tightening its hold on the mutual funds since last 2-3 years during which time it has made substantial regulations in the interest of retail investors. Last year (1st Jan’08) it announced zero entry loads for direct investments (i.e., direct applications to AMC) in mutual fund schemes.

Now, a few days back, sebi has decided to completely scrap entry loads in new as well as current mutual fund schemes (Note: Decision already taken in Sebi board meeting held on 18th June, 2009 but yet to be notified). As per the existing practice, around 2.25% is deducted towards distributor commission and marketing expenses and balance 97.75% of the amount gets invested in the fund.

Investors would now have to pay the mutual fund distributors commission / fee directly based on negotiation and mutual understanding. Sebi is also making it mandatory for distributors to disclose the commission––trailing or any other––to the investor.

Getting rid of entry loads: Consequences

Effectively, now there will be:

1. Variable Upfront fee instead of fixed percentage
2. Competition among distributors
3. Direct negotiation between investor and distributor
4. More awareness & direct control of investor
5. More emphasis on existing schemes
6. End of unethical practice of rebating
7. Unbiased advice

AND it will result in following benefits to mutual fund investors:

1. More Transparency (Investor will know the exact cost of investing)
2. Lower transaction costs
3. Better quality of service
4. Curb on mis-selling of NFOs
5. Lower churning of portfolio
6. Emergence of fee based financial planning

Initially, this investor friendly reform may give an edge to life insurance industry as the gap between commission structure of life insurance products and mutual funds schemes will widen and might result in more pushing and mis-selling of ULIPs. However, let’s hope that better sense prevails over IRDA and it learns some lessons from SEBI about regulating Life Insurance Industry, so that there’s a level playing field.

UPDATE (July 1, 2009): To implement the above measures, SEBI has issued a circular (SEBI/IMD/CIR No. 4/ 168230/09) on 30 June, 2009 vide which the above provision becomes effective from August 1, 2009.

It shall be applicable to investment in all existing mutual fund schemes (including additional purchases and switch-in to a scheme from other schemes) as well as new mutual fund schemes launched on and after August 1, 2009.

In fact, the circular goes beyond that and introduces one other innovative measure regarding exit load /CDSC (Contingent Deferred Sales Charge). The circular states that AMCs can no longer retain more than 1% of exit loads/CDSCs to meet various marketing and selling commission (including payment of commission to distributors). Any amount over and above one per cent of the redemption proceeds will have to be credited to the mutual fund scheme immediately. This provision has also been made applicable to all redemptions from mutual fund schemes (including switch-out from other schemes) with effect from 1st August, 2009.

This will discourage AMCs from charging exorbitant exit loads/ CDSCs. And, if they do so it will be for the benefit of existing investors only.


Interest on Savings Bank Accounts
At present, banks calculate interest on savings bank account at the rate of 3.5 per cent per annum calculated on monthly basis (though credited to saving bank accounts on quarterly basis) on the minimum balance lying in your saving deposits account from the 10th to the last date of each month. Put simply, while withdrawals are deducted, fresh deposits after 10th are not considered for interest calculation. Does it make any sense?

As per the circular no. RBI/2008-09/452 dated April 24, 2009 to be effective from April 1, 2010, RBI has instructed all scheduled commercial banks to calculate interest on saving bank accounts on a daily product basis. Perhaps, RBI has become wiser and started thinking in the interests of investors / customers.

Effectively, this will increase your interest earnings from savings bank account by almost hundred per cent. For example, if you used to earn a interest income of, say, Rs 2,500 annually; from financial year 2010-11 onwards it will work out to be roughly Rs 5,000 i.e. double the present amount.

Although, it won’t make much difference in your finances but don’t forget every penny counts.


Next part: Health Mediclaim Insurance – Latest IRDA Guidelines


Also see:

1. 6 Myths about Mutual Funds
2. 10 Practical Tips about PPF Investment
3. Section 80C Tax Planning – 10 Smart Tips
4. Health Mediclaim Policy - IRDA Guidelines 2009
5. Budget 2009 - Review of Tax Proposals Impacting Individuals
6. 10 Principles of Mutual Fund Investing
7. Investor Reforms (#3): Cap on ULIP Charges

Amazing Facts about Income Tax - Tax Rates

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I’ve already covered a few amazing facts about Indian income tax where it is discussed how in some cases income tax is imposed without earning any income.

But there are certain other amazing facts about Income tax. Here, I discuss a list of few amazing facts about “Income Tax Rates”:

Highest income tax rates in India
Can you ever imagine that at one time, highest personal income tax rate in India was more than 90%?

During Indira Gandhi’s regime in 1973-74, India’s personal income tax had eleven tax brackets with highest marginal income tax rate of 97.5 per cent. Just imagine paying Rs 97.5 to the government out of every Rs 100 earned. Well, sounds rather scaring, doesn’t it? This kind of laws only helps in sowing the seeds of corruption.


Maximum marginal rate of tax
If your taxable income falls in the range of Rs 10 lakh to Rs 10.30 lakh, then what’s your maximum marginal rate of tax? Just try to guess! It is 103%. Put another way, the marginal tax you pay on your income between Rs 10 lakh and Rs 10.30 lakh is more than your additional / marginal income. Isn’t it amazing? But, how is it possible?

It is because the moment your income crosses the mark of Rs 10 lakh, you become liable to pay a surcharge of 10% on tax. But isn’t it that the marginal relief is allowed to ensure that the tax payable by levy of surcharge of 10% doesn’t exceed the amount of additional income in excess of Rs 10 lakh? Yes, of course it is allowed; however, there is no marginal relief against education cess of 3% which is levied on basic tax PLUS surcharge and as a result your marginal tax rate becomes 103%.

Let’s consider an example: Suppose you’re a 40 year old male resident individual and your taxable income is Rs 10 lakh for the financial year (FY) ending March 2009. Now, as per the applicable tax rates for the income earned during the previous year (08-09), your total tax liability works out to be Rs 2,11,150 which includes a basic tax of Rs 2,05,000 and surcharge of 6,150. Further let’s increase your income by, say, another Rs 30,000 so that your taxable or “Net Income” becomes Rs 10.30 lakh. Now based on the tax slabs your revised total tax liability comes to Rs 2,42,050 (tax of Rs 2,14,000, surcharge of Rs 21,000 and education cess of Rs 7,050).

Put simply, if you’ve a taxable income of Rs 10 lakh, you’re left with a net amount of Rs 7,88,850 in hand after paying a tax of Rs 2,11,150. On the other hand, if your taxable income is Rs 10.30 lakh, you are left with Rs 7,87,950 after paying a tax of Rs 2,42,050. In other words, additional earnings of Rs 30,000 make you poorer by Rs 900. You can verify the above calculations yourself by taking the help of Income Tax Calculator.

It implies that it is better to forego the additional income or donate it to a charity rather than paying the tax.

Now there’s another teaser for you: What’s the break even point i.e. at what level of income your additional tax becomes equals to the additional income? (Note: There will be slight difference in case of senior citizen and women assesses).


Maximum tax rate required in a Utopian Society
Just imagine for a second if everybody starts paying tax dues honestly, at what rate of tax government will be able to collect the same revenue. I think 5 per cent will be more than enough. OK, now come out of the dream.


Also see:

1. Life Insurance – Most Amazing Fact

2. Marginal vs. Effective Tax Rates

3. Income Tax Calculator FY 2008-09

4. Taxation of Notional Income

5. Income Tax Calculator FY 2009-10

Life Insurance - 5 Common Myths & Misconceptions

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In this series of myths and misconceptions, I am trying to highlight / demystify various false notions associated with Personal Finance. I’ve already covered quite extensively the fallacies linked to tax, credit cards and mutual funds. Here’s top 5 myths & misconceptions about Life Insurance:

Life Insurance: 5 Common Myths & Misconceptions

Misconception #1: Insurance is a tax saving tool
The biggest myth about life insurance is that it is considered a tax saving tool rather than risk management tool. People buy it for the sole purpose of saving tax. There is nothing wrong in considering tax benefits while applying for it but buying it solely for tax savings is wrong.


Misconception #2: Nominee is same as the legal heir
Nominee is the person who’s entitled for the claim proceeds if the life assured dies and is meant to give valid discharge to the life insurance company. Put another way, nomination only indicates the person who’s authorized to receive the claim amount and need not be a legal heir of the life assured.

Thus, nominee doesn’t acquire the absolute right over the proceeds if he is not the legal heir or the beneficiary in the will or if he is only one of the legal heir or beneficiary. The other legal heirs or beneficiaries can contest the ownership of the claim proceeds.


Misconception #3: ULIPs are equity linked
A common myth about ULIPs (Unit Linked Insurance Plans) is that they are linked only to equity markets.

The fact is that there are various fund options (differs from company to company) available in case of Ulips. However, we can broadly categorize them into three categories 100% equity fund, balanced fund and 100% debt fund. There are also other fund options available with varying degree of equity and debt.

You have the flexibility to choose a fund option based on your risk appetite and if you wish, you can switch to another fund option at a later stage.


Misconception #4: Life Insurance is more important than Personal Accident / Disability Insurance
Absolutely wrong. Risk coverage for personal accident and disability is much more important than life insurance. Before you go for life insurance, you should be adequately covered for personal accident and disability insurance. Why?

1. While life insurance covers only death whether natural or accidental, personal accident also covers disability (both temporary and permanent) caused due to accident (besides accidental death) and disability insurance covers you for non-accidental disabilities arising out of various diseases / ailments.

2. In terms of financial impact, suffering from life impacting disabilities is worse than dying.

3. The probability of meeting an accident or suffering from a disability is much more than natural death, particularly for younger people.

4. Finally, these general insurance covers are much cheaper than life insurance.

However, please note that these policies don’t cover you for hospitalization (for which separate risk covers are available) expenses but for loss of income arising due to disability.

Unfortunately, as of now, disability insurance also called 'Income Replacement' or 'Income Protection' insurance is not available in India.

The next best alternative to insure against the risk of sickness induced disability is critical illness insurance which differs from disability insurance in terms of coverage and benefits with some some overlaps.

Misconception #5: You should receive the money back when the life policy expires
How much annual premium do you pay to get your motor comprehensive cover on your 4 lakh or 6 lakh car? Do you get that money back when your motor car policy expires? But you expect your money back while buying a life insurance policy. Isn’t it amazing? To know more of it, see: Most Amazing Fact about Life Insurance.

Also see:

1. Understanding Life Insurance
2. Life Insurance: Various Exit Options
3. Section 80C: 10 Smart Tips
4. 10 Common Myths & Misconceptions about Tax
5. Top 6 Myths & Misconceptions about Mutual Funds
6. Credit Cards: Hidden Traps
7. 7 Things to Know about Life Insurance

Income Tax - 3 Other Sources of Confusion

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Some of the most common tax confusions were discussed in the previous post, 5 Common Tax Confusions. Here’s another three:

1. Difference between exemption, deduction and rebate
Do you know the difference between the three different methods of providing tax concessions: exemption, deduction and rebate? Actually, most people get confused between the three and use them interchangeably. Broadly speaking, exemptions and deductions both reduce your taxable income, while rebate reduces your tax.

Now, tax exemptions and tax deductions both reduce your taxable income. But the manner of reduction is different. Exemption doesn’t form part of your total income whereas deduction first forms part of your total income and later deducted from it. For instance, while PPF interest is exempt, NSC interest is taxable but deduction is allowed under section 80C. To understand how it affects your tax planning, check out – PPF vs NSC.

The most common example to illustrate the difference between deduction and rebate is the benefit of long term savings given to individuals. Up to AY 2005-06, rebate was allowed under section 88 which got replaced by deduction under section 80C by the Finance Act 2005.

2. Difference between AY, FY and PY
The other basic tax confusion is about Assessment Year (AY), Financial Year (FY) and Previous Year (PY).

Unlike calendar year which starts on January 1 and ends on December 31, a financial year (FY) is considered to be from April 1 to March 31.

Under the Income Tax Act, income earned in a financial year (FY) is taxed in the next FY. The FY to which the income belongs is called the previous year (PY) and the FY in which the income is taxed is called the assessment year (AY).

For instance, the income earned during FY 2007-08 is assessed for tax in the FY 2008-09. Here, FY2007-08 is called PY and FY 2008-09 is called AY.


3. Difference between tax planning and tax evasion
First, tax planning is your right and is perfectly legal. Every tax payer has a right to plan his finances in such a way as to minimize the payment of taxes without violating the legal provisions. Put simply, through tax planning you can reduce your tax burden, by taking advantage of exemptions, deductions and reliefs provided under the Income Tax Act, 1961. But the moment it crosses the threshold of law, it becomes tax evasion and is prohibited. Tax evasion involves unfair methods and malafide intention (intention to deceit) to conceal income which is otherwise taxable.

Furthermore, there is another term called ‘tax avoidance’ which falls between tax planning and tax evasion. It is an attempt to dodge tax in legally permissible ways by taking advantage of certain loopholes in law. Technically, it is legal (i.e., there is no breach of law) but is against the legislative intent. Anyhow, tax avoidance has also got the judicial sanction as per the ruling of the Supreme Court of India in UOI vs. Azadi Bachao Andolan (2003).

For example, while designing your salary structure in such a way as to claim maximum HRA exemption is tax planning, making a false claim for HRA exemption without paying any rent is tax evasion, and paying rent to a spouse just to avail HRA tax exemption is tax avoidance.

Also see:

1. 5 Common Tax Confusions

2. 10 Common Income Tax Fallacies
3. 3 Other Kinds of Tax Returns
4. Income Tax Calculator

Health (Mediclaim) Insurance policy - 10 Practical Tips

Buying a health insurance is like making any other purchase. There are different types of health insurance policies available depending on your requirement and your budget.

Photo by Lakeland Chamber

It is important to choose a suitable policy as per your needs the first time around because unlike motor insurance, as of now, the portability (switching from one insurer to other without losing the renewal and no-claim benefits) of health insurance is not there. Therefore, a little research at the buying stage itself can save you a lot of money and hassles later. Besides, knowing exactly what you’re buying gives you peace of mind. Thus, before buying the health policy, do remember these finer points / tips:

How to buy Health (Mediclaim) Insurance: A Guide

1. Have a valid reason
No doubt, health insurance is becoming as important–if not more–as the life cover. However, keeping in view your individual circumstances and requirements, you should have valid reasons for buying the health cover. Don’t buy it just for the sake of having one or to claim section 80D tax benefit under IT Act.

2. Amount of health coverage
You need to have adequate coverage and avoid either over-insurance or under-insurance. But there’s no best way to decide the optimum coverage. The total amount of coverage required depends on many factors like number of family members to be covered, your estimate of medical costs (which depends on factors such as your life-style, the kind of hospitals you generally prefer, the city of residence etc) your existing health coverage, if any (such as employer provided group health policy).


3. Cheapest or lowest cost policy may not be the best policy
With a wide array of health insurance products available in the market, choosing the best product as per your requirement is really difficult.

However, remember that cost isn’t the only criteria when buying health insurance. In addition to affordability of the premium you need to consider many parameters before finally choosing your health policy. For example, you have to take into account factors such as inclusions and exclusions, no claim benefits offered for every claim free years and TPA (Third Party Administrator) hospital network.

It is very important for you to make sure that your family hospital or clinic (where you seek medical advice and treatment) and also the hospital near your home (for seeking emergency medical help) are part of the insurer’s network of hospitals for cashless settlement of claims.


4. The first health Cover
The first health cover you require is an indemnity cover (which reimburses the expenses actually incurred) because the basic premise of health insurance is to take care of medial expenses in case of hospitalization.

Therefore, if you’re a first time buyer, go for a normal health or mediclaim policy and thereafter, if required, increase the coverage through various specific health insurance policies.

After having a basic indemnity policy (also called mediclaim policy), you may go for defined benefit plans such as Critical Illness and Daily Cash Hospitalization (DCH). However, buying a health-cum-investment plan is strictly no-no.

Furthermore, don’t buy a regular mediclaim policy with a sum insured greater than Rs 2 to 3 lakh or, at the most, five lakh. Why? See point no 7: Top-up health policy.


5. Better to opt for a family floater
Floater policies are cheaper than individual policies. Chances of all the family members falling ill at the same time or with in the same year are low and therefore combined higher limit can be used by any individual member. Unlike individual mediclaim plans, in case of Family Floater mediclaim plans availment of sum insured is not restricted to one individual. Put simply, anyone or all members of the family can avail the benefit simultaneously within the limit of total sum insured.

For example, rather than buying an individual mediclaim of, say, Rs one lakh each for three members of a family, it is better to buy family floater plan of Rs 3 lakh. Even floater plan of Rs two lakh will do because while overall cover would be reduced by 1/3rd, individual coverage is doubled.


6. Have a separate cover for Parents
While opting for floater mediclaim plans it is better to have a separate policy for your parents because in case of floater plans age of the eldest member is considered for the purpose of calculating the premium. So by avoiding clubbing your parent’s health cover with your own cover, you can save a lot of premium.


7. For Increasing the Coverage, go for Top-up Policy
It is always better to buy a top-up policy for any coverage beyond two to three lakh or, at the most, five lakh. By combining your regular mediclaim health policy with a top-up or super-top up policy, you can save considerable premium without compromising your total coverage.


8. Know the exceptions
Do you want to wait until you’re sick to discover that your mediclaim health policy doesn’t cover the particular ailment? Therefore, it is very important that you understand the level of coverage available under the mediclaim health policy. It’s essential to know about the inclusions and exclusions of the mediclaim policy.


9. Group policy vs Independent policy
Most companies provide health covers to their employees under a group health plans; however, it still makes sense to sign up for an independent policy because you’ll no longer be covered in case of job loss or job transition (your new employer may not provide it) or withdrawal of cover by the employer.


10. Filling up the form correctly / Disclosure of health particulars
Finally, it is utmost important that you fill up the form correctly. Fill it carefully, particularly the health declaration part and ensure that you don’t lie about your existing health status. Disclose your existing health details HONESTLY because non-disclosure or false declaration can lead to rejection of a claim in the future. For this, don’t even rely on your agent or the company because it happens that sometimes they don’t advise you properly since they fear losing out a new customer. Therefore, always go by the written word.

At last, your job doesn’t end with the buying of the right health policy. You also need to ensure that you renew it every year before time because otherwise all your hard work will go down the drain. For details, see: Why you need to renew your health policy before time.

If you think, I’ve left out anything important, please mention in the comment section.


Also see:

1. Difference between Mediclaim and Critical illness
2. 5 Reasons for Timely Renewal of Health / Mediclaim Policy
3. Inclusions & Exclusions of Health / Mediclaim Policy
4. Understanding Life Insurance

Income Tax Calculator (PY 2008-09, AY 2009-10)

I’ve already talked about how to calculate your income tax liability in an earlier post.However, some of you might not be interested in calculating your tax liability on your own, or don’t want to put unnecessary effort in understanding complexities & intricacies of tax laws. DON’T WORRY. There's an easy way out.

Photo by Felix Idan

Income Tax Calculator (PY 2008-09 & AY 2009-10):

Here's a ‘TAX CALCULATOR’ by “The Money Quest” which will provide you with a correct estimation of your income tax liability for the financial year 2008-09 (Assessment Year 2009-10).

Notes / Instructions for Using Tax Calculator:

1. The calculator is meant only for tax calculations of residents individuals. In other words, it is not applicable for non-residents.

2. It is presumed that there is no agricultural income.

3. This calculator is meant to calculate tax provided you know your GTI (i.e. Gross Total Income). GTI includes all your taxable income under various heads of income (Salary, House Property, Income from Business & Profession, Capital gains and Income from other sources) after excluding all your exempt income (i.e. income which is not taxable) and also after set off and carry forward of losses of current year & earlier assessment years.

4. Please note that LTCG on equity shares or equity oriented mutual funds on which securities transaction tax has been paid are exempt from tax u/s 10(38) and therefore doesn't form part of long term capital gains (LTCG). So, ensure that you exclude it from GTI also.

5. Please also note down that "Incomes subject to special rates of tax" is to be included under GTI and also to be mentioned separately under the relevant column in the tax calculator.

6. In the “Tax Payer Status” column, please enter 1 for senior citizens [i.e., if you’re an individual (man / women) above 65 years at any time during the year 2008 – 09 (Apr 2008 – Mar 2009)], 2 for Women and 3 for other individuals.

Before filing your tax returns for the current assessment year (AY) 2009-10 (PY 08-09), make sure to cross-check your tax liability with the help of this calculator.

I’ve tried my best to make this income tax calculator hundred per cent accurate for application under different scenarios of income. Still, if you notice any bug, just leave a comment in the comment box below and I’ll do my best to make the necessary correction in the tax calculator.

Finally, can you answer this money teaser?

Suppose your ‘Taxable Income’ / ‘Net Income’ is Rs 10 lakh and your employer offers you a bonus of Rs 30,000. Will you accept the offer? Why or why not?

UPDATE (July 16, 2009): For answer to the money riddle, see Amazing Facts about Income Tax Rates. And, if you’re looking for a tax calculator to calculate your tax liability for the current financial year 2009-10 (AY 2010-11), go to TAX CALCULATOR FY 2009-10.

Also see:

1. How to Calculate Your Taxable Income
2. How to Calculate Your Tax Liability
3. How to Calculate HRA Tax Exemption
4. HRA Tax Calculator

5. Effective Tax Rate Calculator

Hidden Flaws of Spending: Individual Specific Flaws (Part II)

This post is in continuation of earlier post: Individual Specific Hidden Spending Flaws (part I).

Photo by tracitodd

Relative Wealth
Sanjeev Pandiya writes about human irrationality [Monkey Button I] in the recent edition of Mutual Fund Insight published by VALUE RESEARCH, a mutual fund research company:

“My car is bigger than yours: If only we could get over this, a large part of the luxury car industry would disappear. Almost all discretionary expenditure happens because we have this yearning for ‘relative wealth’. It does not matter what we earn/get, as long as it is more than others.

Many experiments have shown up this irrationality. The root cause is hidden in Darwinian rules of natural survival: a sense of shortage of all life-giving resources, which is why “I, me & mine” has got preserved in us as instinct. Not only do I want to survive, I want to do it at the expense of my competitor.

A logical extension of this is the concept of ‘relative wealth’, which kicks in, the moment we cross our threshold of basic needs. Maslow called it ‘ego’. As we move up the chain of discretionary expenditure, we can extract large savings from switching our mind to not caring much for this ‘relative wealth’. You will save money on cars, houses, travel, social expenditure, etc. Almost all your credit card expenditure will go to zero.”

Mental Accounting
Mental accounting is a term coined by Richard Thaler, Professor of Economics and Behavioral Science at the Graduate School of Business, University of Chicago, considered to be the inventor of field of Behavioral Finance.

Mental Accounting affects how and how much we choose to spend and has enormous ramifications in our daily life. For example, treating money differently depending on its source – Doesn’t we tend to spend a lot more on frivolous consumption out of income sources seen as one time events and viewed as windfall profits (such as lottery winnings, legacy, bonuses, dividends, gifts, tax refunds, and money received back from life insurance policies) compared to normal paychecks?

Mental accounting also explains why many of us keenly grab bargain on things we do not require. When something sells for lower than the mental price we have assigned it, the deal takes priority over the actual utility of the item. It’s like buying a big size doormat; simply because, on a sale, it is available at the prize of small size mat, although our requirement is only for a small size mat. That way, we are able to make a saving in our mental account.

Following are the other good examples of mental accounting bias coming into picture and making illogical use of money:

1. Spending more when using a credit card than making cash purchases.

2. Money lying idle in bank account while carrying substantial credit card debt or personal loans.

3. Business organization being less concerned about ‘capital expenditure’ than ‘revenue expenditure’ just because capital expenditure is not routed directly through profit and loss account.

4. Viewing discount in relative rather than absolute terms. For example, going great lengths to avail discount of Rs.10 on purchases worth Rs.50, whereas not being much concerned about same Rs.10 discount while making a spending decision involving Rs.1000. Although, in percentage, it is twenty per cent and one per cent respectively, but the absolute amount of discount remains same in both the cases.

For more such examples, see this post by Harish Rao on Mental Accounting.

Mental Budgeting
Mental accounting has ramifications in budgeting also. Rational thinking dictates that if there is a potential saving under one category, it should either be directed towards shortage, if any, under any other category or should go towards savings.

In contrast to rational thinking, mental budgeting predicts that once we earmark a particular amount for a specific purpose, we tend to spend until funds are depleted under that particular category, irrespective of shortage/excess in any other category. For example, suppose we allocate Rs.4000 per month on food expenses based on our past few months spending, and suddenly the food prices decline considerably and, as a result, there is a surplus of, say, Rs.1800. Instead of shifting this surplus “food money” to another category, where there may be a shortage of funds, we overlook this opportunity and tend to spend more on food consumption.

Consider the anecdote mentioned by Heath and Soll:[Mental Budgeting and Consumer Decisions, The Journal of consumer Research, Vol. 23, No. 1 (Jun., 1996), 40-52]

“Mr. P recently went shopping for a pair of slacks. When he could not find any slacks he liked, he spent a similar amount of money on a sweater that he normally would not have purchased.”

Another good example is imposing tight limits on grocery purchases; however, freely spending while dining out, because grocery purchase comes under food money while dining out comes under entertainment expenses.

High Debt and Misuse of Credit Cards
Lure and availability of easy credit is also a major factor responsible for our obsession with material goods. Few moments of shopping ecstasy can result in months and years of indebtedness. Money that goes to pay interest, late fees, and other charges makes it tough to channel money for savings.

The major factor behind the popularity of credit cards is called decoupling, which means separating payment from consumption. When we pay the cash, we feel the loss right away, which is not the case in using credit cards, where the feeling of pain associated with making the payment gets postponed till the receipt of credit card statement. Moreover, with credit cards the connection between specific purchases and specific payments gets obscured; thus, resulting in further decoupling of payment from purchase.

Paying Ourselves Last
The most important and effective principle of personal finance is to always “Pay Yourself First”. However, most of us do exactly the opposite i.e. Pay Ourselves Last.

In a traditional way of saving, spending gets priority over savings; meanwhile, some other expenses come up and, in the end, usually nothing is left over.

Ignoring True Cost of Ownership
TCO is a method which considers operating costs incurred during the lifetime of an asset in addition to acquisition / purchase cost of an asset. Put simply, it means considering all relevant costs of an item before making a purchase decision.

However, we tend to buy things like expensive gadgets, cars, and houses just because we don’t have any alternate plans for the money, and further these decisions are made without having any idea of the whole picture involved i.e., by ignoring the true and total cost of ownership.

If you can come up with any other flaw in our spending habits, please mention in the comment box.

Also see:

1. 10 Reasons Why you Need a Savings Plan

2. Savings - A Step Towards Sustainable Living

3. Hidden Flaws of Spending - Why do make Fatal Money Mistakes

4. Hidden Flaws of Spending - Individual Specific Flaws (Part I)

5. Hidden Flaws of Spending (#3) - Marketing Gimmicks