(Disclosure: Some of the links below may be affiliate links)
You have probably already heard of lifestyle inflation. I have already talked a bit about that since I fell into this trap. It is an essential subject because many people are subject to it. And lifestyle inflation can ruin your financial life. It is essential to learn how to avoid lifestyle inflation!
Lifestyle inflation is happening when your spending is going up and up. Many people, when they get a raise or some extra income, simply spend it all. They do not only do it for one month, but they also do it the next month as well. And the following time they get a raise, they do the same. Some of them can afford it, but some people go into debt in that vicious circle.
The main problem is that most people do not consider everything there is to consider when getting some extra income. For instance, they do not consider that they will have to pay more taxes when they get more income. And they do not take into account the upkeep costs of some of the things they buy. Moreover, they also do not think of their retirement. The more you spend each month, the more difficult it is to retire.
In this post, we are going to discuss lifestyle inflation. I am also going to talk about a few rules you should consider if you want to avoid, or limit, lifestyle inflation.
Lifestyle inflation is something we already talked about a bit on this blog. It is a big problem for many people. A lot of people who have a significant income are not wealthy at all because of this issue.
The issue is simple: The more income you get, the more money you want to spend. And in the end, you are no richer than any person with half of your income. It may sound surprising. But this concerns a lot of people. Most people, when they get a raise, do not increase their savings, only their spending.
It is not very difficult to explain. Most people only think about spending. As long as they have little money left at the end of the month, they do not care more. And if they get a raise, they are still happy with the little money they can save. And often, these savings are just there for vacations anyway, not for real savings. If you save 1000 dollars per month when you get 5000 dollars per month, it is excellent savings. If you still save 1000 dollars a month when you earn 10’000 dollars a month, it is not as good anymore.
There have been stories of people getting bad debt because of a raise. Some people will laugh at stories like that, thinking that a raise can only make people richer. But these stories are true. If not handled correctly, a salary raise can have a very negative effect on your finances.
And actually, this is expected of you by society. People are assuming that people with large incomes have large houses, nice cars, nice suits, and even expensive hobbies. I think it is pretty dumb. But that is the way it is. Many people wonder why we are living below our means. We could afford a much bigger car, for instance. But it does not serve our future financial goals.
You will also probably be pressured by your peers. Once you move up the ladder at work, you may find out that you are the only one left going to work in your small car while the others all have big BMW cars. Even though your small current works well, you may want to upgrade into that big BMW. It sure will not get you better to work. But that is often all the same to people. The same stands true of houses and neighborhoods.
If you intend to retire at 65 or 70, this is probably not such a big deal. You can probably count on social security to help you go through retirement. But social security will not help through early retirement. Therefore you may have to retire later than you thought. And it will be more difficult, although not impossible, to retire early. If that is your goal, you are better off limiting your expenses.
High income does not make you wealthy
As I said before, a lot of people with substantial incomes are not rich, millionaires, or wealthy people.
A lot of them have more debt than people with a smaller salary. Some of these people would be surprised that when computing their net worth, they would find a negative value!
If you do not consider all the facts about a raise, you may well end up in the same situation. Once you start spending more and more, you will find it is challenging to keep up with the Joneses. It is a very vicious cycle. If you do not consider all things such as taxes and upkeep costs, you may well end up in trouble, only being able to pay debts and to take on more debts to sustain this cycle. And every new income will just go towards increasing this debt.
Most wealthy people have a significant income. But they did not succumb to the trap of lifestyle inflation. They are frugal, and they keep their debts to a minimum. Moreover, they are also investing their savings, which makes up a large part of their income. Living below your means is how you get wealthy, not by following the Joneses!
My experience with lifestyle inflation
I have been a victim of lifestyle inflation. Not really a victim, of course, it is all my fault. There is no point in blaming lifestyle inflation. It is all on me. And it is not a bad story since my financial life is now much better. But it could have been even better had I realized my problem earlier.
When I started my Ph.D., I got a small salary since I was only being paid at 65%. But it was enough to live without any issues and with some money left. At this point, I started saving some money. It was not much, about 10% of my income.
Then I got a significant increase in salary when I was able to take on extra charge and increase my work to 85%. Instead of saving that extra money, I went on spending more. That is when I started to accumulate many servers at home. I do not regret it since it was a lot of fun. But that money would have much more useful if invested in the stock market. Nevertheless, I was still able to save some little money, about 10% of my income.
But at that point, I was satisfied with that amount of savings. I was thinking I was saving enough. But after a few years, I finally realized that I have only been saving a tiny fraction of my salary, and even though my salary increased, so did my spending. I just discovered lifestyle inflation!
I am not claiming my story is a disaster! This story is just a common example. There are also some extreme examples when people get into financial trouble.
Take everything into account
There is something that many people do wrong when they get a raise. They take into account the raise as if their real income will increase that much. But this is not the case.
First of all, your gross salary is not your net salary. I do not know about every country. But for instance, in Switzerland, about 10% of your gross salary directly goes away, and you only receive the rest as your net salary. It is the same in many countries. So if you get a raise of 1000 dollars per month, you will only see 900 dollars each month. It is imperative! If you start spending 1000 extra dollars and only receive 900, you may be in trouble.
Secondly, if you get more salary, you will also have to pay more taxes at the end of the year. And extra money is taxed at your marginal tax rate, which increases as you earn more. So if your marginal tax rate is 30% and you get that extra 900 dollars net a month, you will have to pay 270 dollars in additional taxes each month!
In the end, out of a 1000 raise, you may only be able to spend 630 dollars of it each month. Again, it is imperative to consider all the facts correctly. Because if you plan to spend it the 1000 dollars each month, you will be in a world of trouble once you have to pay taxes.
Consider upkeep costs
Another thing to take into account is that when you buy something, you may also increase the upkeep costs of your budget.
For instance, if you buy an expensive car instead of the simple one you got before, not only you have to pay for the vehicle itself, but you also have to pay for the maintenance of the car. Expensive cars tend to have costly maintenance costs. But many people do not consider that.
The same stands true for a huge house. If you buy a home with ten rooms and a large plot, you can be sure to have much more maintenance costs than if you purchased a small apartment with three bedrooms.
You should consider this for every purchase, not only when you have extra income.
Do not use a fixed savings rate goal
Using a fixed savings rate is a bad idea.
It sounds like a good idea at first to save 20% of your income. Or even 50% of your income. But once your income grows, you will only save a small part of the extra part. And you will spend the other part. For instance, if your savings rate goal is 25%, you will spend 75% of the extra income. This is direct lifestyle inflation.
You can have a savings rate goal, of course. But you should not be content with it. It is better to have a monthly spending limit as a goal. That goal will not be subject to lifestyle inflation. On the contrary, it will prevent lifestyle inflation.
The savings rate is an important financial metric. If you want to learn about other metrics, I have a list of 10 financial metrics that you could start following.
Work towards your goals
If you are serious about personal finance and you have an objective in your life, you should have set goals for yourself.
Once you get extra income, you should make sure that this additional income works towards these goals.
You can even go a bit further and write an Investor Policy Statement (IPS) that will decide how you react to extra income. Your goals should go into the direction of the IPS.
Once you are clear with your goals, every bit of extra income will help you and hot hinder your progress.
Inflation is sometimes okay
This post is not here to say that lifestyle inflation is always a bad thing. You just need to be extra careful about it! There are some cases where it is perfectly fine, and sometimes even necessary.
For instance, having a new baby and not having any room left in a small apartment may mean switching to a new apartment or house with at least one more room. That way, the life of every person from the family will be more comfortable. On the other hand, you should not use a new baby as an excuse to buy a house with five more rooms!
Sometimes, as you climb the work ladder, it may become necessary to invest in a new wardrobe. There are many jobs where you cannot dress any way you want. That sometimes means you need to buy a few new suits. Sometimes, this can also help you climb the ladder even faster.
Another thing I would consider okay is to increase one’s quality of life. For instance, as you get more income, you may want to hire a cleaning aid. That could save you precious time that you can then spend with your family or for your favorite hobby. You should not ignore the quality of your life.
There are more examples of that, of course. But by now, you should get the gist of it! And of course, this highly subjective. Some people value more things than others. And it is perfectly fine!
There is nothing wrong with celebrating your new income! You have worked hard for it, and you deserve a celebration. Even if you end up using the extra income in the first month, you can live with (or without actually) it. Just make sure this expense will come back again the following month.
You can celebrate with a nice dinner out or by buying a nice thing you always wanted but have delayed for a long time. But do not get into debt and do not make the mistake of celebrating several months in a row. If you do that, you will have fallen directly into the trap of lifestyle inflation.
If I get a nice raise or a bonus, I will surely celebrate. I will probably buy something that has been on my buying list for a long time. And I will probably go out for dinner with Mrs. The Poor Swiss. But as soon as these expenses are done, I will go on saving more than before the extra income.
What is lifestyle inflation?
Lifestyle inflation is the fact that people spend more as they earn more. Lifestyle inflation causes high-income earners not to be as wealthy as they could.
What is lifestyle creep?
Lifestyle creep is the same thing as Lifestyle Inflation. Lifestyle inflation is the fact that people spend more as they earn more. This causes high-income earners to not be as wealthy as they could.
You should now realize that extra income may not be as good as you thought it would be. In fact, for many people, extra income may be a big trap. However, if you are aware of this and you follow a few simple rules, this extra income will help you towards your goal. In that case, working towards increasing your income can go a long way in speeding up your journey.
Every time you get extra income, you should make sure that it works towards your goal. Of course, you should have goals in the first place. Just make sure you do not use a fixed savings rate goal. Then, for extra income, you should consider taxes and fees. When you buy something, you should also consider upkeep costs.
But do not forget to celebrate a bit. There is nothing wrong with spending some of this extra income. You can go out and have a nice dinner. You can buy something you have wanted for a long time. If it is recurring extra income, such as a raise, you can even entirely spend it the first month. Just make sure you do not do it several months in a row!
Lifestyle inflation is also a danger for Financial Independence. And it is especially dangerous for very high-income earners.
Have you ever fallen to the trap of lifestyle inflation? How do you fight it?