We go about our financial lives doing things that don't make a lot of sense through a purely rational lens. One of these common quirks called "mental accounting" is where we separate our money into different piles and we don't treat every dollar the same way. Most people would treat a $100 bill they found on the ground differently than $100 they earned on their paycheck or if one of their investments went up by that same $100. We act almost as if money has a memory and each dollar remembers how it came to us.
A rational way to think about your money is to add up your assets and liabilities to get a clear picture of your net worth and then to spend your money in a way that maximizes your pleasure while saving and investing to meet your goals, keeping in mind your entire portfolio of investments. None of the dollars care about where they came from, you just put them to highest and best use based on the satisfaction of purchases and the rate of return on investments.
We discussed the need to build up and emergency savings account in a previous post. But does it make any sense to put money in an emergency savings account while owing money on a credit card with a 10% interest rate? Not really. If the bank is only paying you 1% on that savings account, you're better off paying down the debt and saving yourself interest in the long run. But what if I have an emergency? Well, that's when you use the credit card and then pay it off. It makes no sense to try to fool yourself into thinking you have emergency savings when you have unpaid debts at the same time. By paying down your credit card, you also improve your credit score and it makes you more likely to qualify for lower interest rate balance transfer offers. Your net worth, adding all debts and assets, does not lie. Your objective in managing your finances effectively is to grow that net worth over time so making sure that you don't pay out interest unnecessarily will speed you along that journey. Along the same lines, when dealing with debts, we tend to prefer the "Avalanche Method" of paying off the higher interest debt versus the lower balance debt ("Snowball Method"). This is after you've made all your minimum payments of course, since you want to avoid late penalties and damaging your credit rating.
The cure for bad mental accounting is to look at your transactions regularly with technology like Mint.com. Mint will make clear to you when you get hit with an interest charge and that irritation may prompt you to do something about it - like stop lying to yourself that you have savings by segregating your money in different mental buckets. Don't fog up your lens and keep your eyes on the goal of growing your net worth.