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You have probably already heard of lifestyle inflation. It is an essential subject because many people are subject to it. And lifestyle inflation can ruin your financial life. It is necessary to learn how to avoid lifestyle inflation!
Lifestyle inflation happens when your expenses go up and up. Indeed, many people, when they get a raise or some extra income, 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 can afford it, but many people go into debt in that vicious circle.
The main problem is that most people do not consider everything 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 consider the upkeep costs of some of the things they buy. Moreover, they also do not think of their retirement and other financial goals. The more you spend each month, the more difficult it is to retire.
In this article, we discuss lifestyle inflation. I also talk about a few rules you should consider if you want to avoid or limit lifestyle inflation.
Lifestyle inflation 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.
This concept 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, you have a good savings rate of 20%. If you still save 1000 dollars a month when you earn 10’000 dollars a month, your savings of 10% is not that good anymore.
There have been stories of people getting into debt because of a raise. Some people will laugh at stories like that, thinking 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, spending more is expected of you by society. People assume 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. Many people keep telling me that I should drive an expensive car. We could afford a much bigger car, for instance. But it does not serve our future financial goals.
You will also probably be pressured into spending by your peers. For example, once you move up the ladder at work, you may find out that you are the only one commuting to work in your small car while the others all have big BMW cars. Even though your small car works well, you may want to upgrade to 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 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. So if that is your goal, you can limit your expenses.
High income does not make you wealthy
Many people with substantial incomes are not rich, millionaires, or wealthy. It is a big personal finance myth that income equals wealth.
A lot of them have more debt than people with a smaller salary. Some people would be surprised to find a negative value when computing their net worth!
If you do not consider all the facts about a raise, you may end up in the same situation. Once you start spending more and more, you will find it 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 paying with debts and taking on more debts to sustain this cycle. And every new income will 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 make 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. 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 much better, and I have never been in debt. But it could have been even better if I had realized my problem earlier.
When I started my Ph.D., I got a small salary since I was only paid part-time (only 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 salary increase when I could take on extra work and increase my salary to 85%. Instead of saving that extra money, I went on spending more. That is when I started to accumulate many servers at home. That money would have much more useful if invested in the stock market. Nevertheless, I could still save a little money, about 10% of my income. And this 10% slowly decreased over time.
But at that point, I was satisfied with that amount of savings. I thought I was saving enough. But after a few years, I finally realized that I had only been saving a tiny fraction of my salary, and even though my salary increased, so did my spending. I just discovered lifestyle inflation! After this, I took control of my expenses, and we are now saving about half of our income. This is what led me to start this blog!
I am not claiming my story is a disaster! This story is just a common example. There are also some extreme examples of when people get into financial trouble.
Take everything into account
There is something that many people do wrong when they get a raise. They consider 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. 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 monthly, you will only see 900 dollars each month. You must consider that. If you start spending 1000 extra dollars and only receive 900 extra, 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 must pay 270 dollars in additional monthly taxes!
Ultimately, out of a 1000 raise, you may only be able to spend 630 dollars on it each month. Again, it is imperative to consider all the facts correctly. Because if you plan to spend 1000 dollars each month, you will be in trouble once you pay taxes.
Do not get me wrong: Getting a raise is good! But you must consider the amount you will get for yourself and not the entire.
Consider upkeep costs
Another thing to consider is that you may also increase the upkeep costs of your budget when you buy something.
For instance, if you buy an expensive car instead of the simple one you got before, not only do 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, a swimming pool, and a large plot, you will 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. This is a mistake that many people make when they automate their money.
It sounds like a good idea 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 essential 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 have an objective, you should have set goals.
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 toward the IPS.
Once you are clear with your goals, every bit of extra income will help you and will not hinder your progress.
Lifestyle Inflation is sometimes okay
This post is not here to say that lifestyle inflation is always a bad thing. However, you need to be extra careful about it! There are some cases where it is excellent 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 in 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 some precious time you can spend with your family or your favorite hobby. You should not ignore the quality of your life.
Keep in mind that time is very limited. So often, it makes sense to spend more to save time.
There are more examples of that, of course. But by now, you should get the gist of it! And, of course, this is highly subjective. Some people value more things than others. And it is perfectly fine! Frugality is a personal matter.
There is nothing wrong with celebrating your new income! You have worked hard for it, and you deserve a celebration. Even if you use 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 or buy something you have always wanted but have delayed for a long time. But do not get into debt or make the mistake of celebrating several months in a row. If you do that, you will have fallen directly into the lifestyle inflation trap.
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 my family. But as soon as these expenses are done, I will save 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 not to be as wealthy as they could.
By now, you should realize that extra income may not be as good as you thought. In fact, for many people, extra income may be a big trap. However, if you know this and follow a few simple rules, this extra income will help you achieve your goal. In that case, increasing your income can go a long way in speeding up your journey.
Every time you get extra income, you should ensure it works towards your goal. 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 spend it the first month. Just make sure you do not do it several months in a row!
Lifestyle inflation is also a danger to reaching Financial Independence. And it is especially dangerous for very high-income earners.
Have you ever fallen into the trap of lifestyle inflation? How do you fight it?
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