Maybe this is your first career position out of college or perhaps you’ve been promoted and your bi-weekly paycheck is about to get a big boost. Rather than continuing to skimp and save on everyday expenses, limiting your credit use, sharing an apartment to keep rent low or biking to work, you go out and move into a one-bedroom condo, buy a new computer and buy a new car – you can afford the payments now, right?
Lifestyle inflation typically occurs when people spend more each time their income increases, rather than adjust their spending, savings and investments to stay on track for reaching their financial goals. While your new income boost may be able to handle these costs in the short-term, over time you may find that small shopping spree could be costing you more than you think.
What is Lifestyle Inflation?
Inflation is when the price of something increases over time; when the price rises, each unit of currency buys fewer and fewer goods (or services). For instance, in the year 2000 the average cost of bread was $1.90 per loaf, but as prices slowly increased that same loaf now costs $3.20. Lifestyle inflation is when the cost of your lifestyle inflates over time.
Say you make $4,000 per month and spend $3,300 per month. Your company gives you a 3% raise to $4,120 per month. Yay — you suddenly have $120 more per month to use on your expenses, paying down debt, and saving for a future need. In your excitement, however, you start buying a coffee every morning and lunch at the cafe next to the office instead of making your own at home, because you can afford it now.
Soon you notice your monthly spending is up to $3,500 and $100 dollars of that raise is not only gone and spent, eaten up by your lifestyle, but you are now spending $80 more a month than before. That’s how lifestyle inflation works, it is a slow financial killer. It doesn’t matter if you make $20,000 or $200,000 it only matters how you spend and save it.
How to Avoid Lifestyle Inflation and Build a Stronger Financial Safety Net
Avoiding the trap of lifestyle inflation is all about financial planning. Try not to increase your everyday expenditures, instead, you make plans for that extra money and use it to further build your financial safety net. Try to keep needs and wants in mind when making realistic, honest assessments about whether a potential purchase is a good financial decision. Here are a few more ways to avoid lifestyle inflation.
Set Your Financial Goals and Stick to It
Take a minute to re-focus on your long and short-term financial goals. Are you saving to take the kids to Disneyland for the holidays, trying to pay down debt or purchase a home. You are less likely to overspend extra money if you understand how it can help you achieve your goals.
Calculate Real Changes to Budget
Before you can have a real idea of how you extra income is going to be spent or saved, take the time to calculate the real effect the money will have on your tax liability and budget. Once you have done the math, you may find that your raise or windfall is not enough to merit a new car or vacation.
Pay Yourself First: Save for Emergencies or Retirement
Once you know exactly how much you are adding to your budget in real dollars, you can avoid overspending by saving and/or investing a percentage that increase. For example, if you currently save 10% of your pre-tax pay for 401 k contributions you may need to adjust your fund to an extra $12 a month. If the money is gone and saved before it hits your bank account, the less likely you are to make a poor financial decision.
For those that do not have an employer-sponsored pension plan, protect the extra cash by making an automatic transfer from your checking to a savings account. If your needs are being met by your current spending limits, deposit the excess directly into a savings vehicle so you don’t spend it needlessly.
Avoid Thinking You Can Afford New Debt
Racking up new purchases on credit cards, financing a new home or otherwise going into debt when you get a raise could have your budget deeper in debt before you know it. Just because you expect to have more money in the future does not mean you can afford to pile up debt.
Sometimes Spending More Makes Sense but Mostly It Makes Sense to Save
There may be times when increasing your spending makes sense. You may need to update your wardrobe to be presentable for a new job or need to purchase a car for more reliable transportation. Perhaps spending a little extra to improve your quality of life – a cleaning service so you have time to relax or spend time with the family – as long as you can afford it.
A certain amount of lifestyle inflation is to be expected as your work and family obligations evolve, but it is imperative that you understand how each spending decision you make affects your financial situation. Make a monthly financial plan to track your spending and saving, then be mindful to plug any extra income (a raise, a windfall or bonus, an inheritance, etc.) into that plan before a penny is spent.
Stick to the ratios of spending and saving that you have set in your budget to avoid lifestyle inflation so you can start or continue to build a financial safety net which meets your goals for an independent financial future.