Roughly 57% of U.S. consumers do not maintain a budget, according to the National Foundation for Credit Counseling. While conventional wisdom suggests that these folks risk overspending as well as poor overall money management, a recent study by a pair of researchers from Brigham Young University and Emory University, offers a somewhat different perspective.
The study, aptly titled “When Budgeting Backfires,” analyzed the way in which our spending habits change when we establish a maximum price to pay before going out to buy a given product. The researchers – Ryan Hamilton and Jeff Larson, who are assistant professors of marketing at Emory and BYU, respectively – conducted a series of consumer surveys in which they asked members of two separate groups to select an item to purchase in a given category of goods, after first directing one of the groups to determine what they’d aim to spend in real life. They found that the group with “salient price restraints” tended to opt for higher priced, higher quality goods.
For example, when the product in question was ballpoint pens, 38.6% of the people without a budget in mind opted for a pen costing more than $0.99, compared to 58.5% of the folks who established a target amount beforehand. When TVs were used, 31.3% of non-budgeters selected the higher priced option, while 54.5% of budgeters did so.
How could that be? Don’t these findings contradict the very value proposition of budgets?
Well, it seems that the process of budgeting can actually throw off the typical value-to-price balance that consumers naturally employ when shopping.
“The reason setting a price restraint can sometimes backfire is because deciding on an acceptable price level first partitions the choice into two stages: first price, then everything else aside from price,” Hamilton told Card Hub. “In a typical decision, we trade-off between price and quality. When we settle on a price level first (e.g., no more than $200), then we disrupt the normal process of making tradeoffs. We’ve already decided that options priced below the limit are acceptable. So how do we decide among those options? We use the remaining non-price attributes, like quality, to help us make a final choice. The result is we are more likely to choose a higher priced, higher quality option than if we had not set the price restraint in the first place.”
In other words, setting a price constraint naturally eliminates products that are either too expensive or too inexpensive, and when left to choose from the remaining items, people tend to opt for whichever has the most features since all of their prices have already been deemed “acceptable.” The item with the most features tends to be the most expensive. Constraining your choices to a particular price range also magnifies differences between products.
“When looking at a smaller set of products, the differences in quality (or features) seem more important,” according to Larson. “If you’re looking at TVs that range in screen size from 28 inches to 80 inches, then the 46-inch TV doesn’t look much smaller than the 50-inch TV. But if you’ve screened out the smaller and larger TVs, then that 4-inch difference looms large. This pushes you to buy the bigger TV, which is likely to cost more.”
This all of course begs a couple of important questions: 1) Should we stop budgeting?; and 2) Do the results change when you pay with plastic as opposed to cash? (OK, the second one might not seem all that important to most folks, but hey, we’re a credit card comparison website!).
To answer the second question first, the tendency to overspend is more pronounced when you’re using plastic, but for reasons other than the price-value trade-off examined in Hamilton and Larson’s study.
“Credit cards create psychological distance between the pleasure of the purchase and the pain of payment,” Hamilton says. “When we pay with cash, we tend to experience those things concurrently. Presumably the pleasure is greater than the pain or we wouldn’t have bought it, but we do still experience those unpleasant feelings as we give away the cash. But when we pay with a credit card, we put off the pain until later. Worse, we disconnect the specific pain that comes from any given purchase by grouping it together with a bunch of unrelated purchases over time. That psychological disconnect is one of the reasons people overspend when shopping with credit.”
That’s certainly interesting nonetheless, so keep that idea in the back of your mind because we’ll circle back to it in a bit.
In terms of whether or not you should rip up your budget as a result of the aforementioned findings, Hamilton and Larson agree that’s taking things way too far. In fact, both offered a resounding “No” when posed with the question.
“No! Don’t stop budgeting!” Hamilton says. “Budgeting is generally a great way to save money. Our research identifies one particular way in which it can backfire, but in general, it is a very good idea. Our hope is that by telling people about this one unintended consequence, people can correct for it and make their budgeting even more effective.”
Don’t worry, we aren’t going to leave you to your own devices in figuring out how to put the study’s findings into action. In order to avoid price restraint-based overspending, Hamilton and Larson recommend:
- Setting aggregate budgets: The type of overspending identified in the study is most pronounced for individual purchases, so if you dilute things by setting limits for broader expense categories (e.g. groceries), you won’t be as likely to spend more than you should.
- Going low: The study speaks to our tendency to push self-imposed limits, so reducing your budget to what you should spend as opposed to what you can spend will help you save.
- Think feature first: For example, if you shop for a 50” LED flatscreen TV rather than a TV that costs up to $800, you’ll be forced to consider what type of product you really want and will be incentivized to pay an amount on the low end of whichever items meet that description.
Now, I promised we’d circle back to the idea of plastic-based overspending and I’m a man of my word. There is something to be said for the financial impact of credit card spending being more abstract than when cash is used. However, there are a number of additional steps you can take to prevent this type of overspending too:
- Avoid impulse buys: Buying with a plan ensures that you only spend money on what you really need.
- Use the Island Approach: Many of us have transformed true luxuries into perceived necessities and are unable to afford everyday expenses as a result. You should never have to leverage credit card debt to pay for things (e.g. food, housing, and entertainment) that you spend money on every month. However, it’s hard to gauge whether or not you’re a chronic overleverager when your monthly purchases are garbled up amidst existing balances. When you use one credit card for everyday expenses and another for debt, finance charges on the former will clearly signal overspending. This type of segmentation will also enable you to get the best possible rewards and the lowest interest rates.
- Review your transaction history regularly: Not only will this help you catch any fraud that might arise, but it will also remind you of the actual dollar value of your card payments.
- Ask for a lower limit: Once you’ve figured out how much you can truly afford to spend each month (including emergency fund contributions), you can ask your credit card issuer to lower your spending limit to that amount. If you have to pay your bill more than once in a given month, you’ll know you’re spending too much.
So, there you have it – a revamped way to approach spending and make your budget work for you. Now it’s time for you to put the information into effect and start saving.
What do you think of the study? Have any other budgeting tips to add? Let us know in the Comments section below!