The dangers of lifestyle inflation

A friend of mine went on a sabbatical last year and returned to work a few months ago. We were having a long day and decided to step out to grab coffee. 

My friend joked that, at the current pace, he might quit again and go on a new backpacking adventure. He then went on to tell me “after all, I now have more money than at the time of my resignation last year. I could totally do it again.”

My immediate reaction: “Wow, how is this possible?” Sure, I have saved quite a bit but I do not think that I would have reached his milestone as quickly. I’ve always known that I spent more than he did but not in significant amounts. Yet, I questioned myself and wondered whether I was not falling into the lifestyle inflation trap despite my best efforts. 

After all, I was the one who purchased a very expensive engagement ring.

What is lifestyle inflation?

Lifestyle inflation is essentially the practice of spending more as you earn more. As a result, the amount you save each month never increases. If you don’t save at all, then you continue to live pay check to pay check although your income increased. Seems wrong, doesn’t it?

According to Investopedia, “lifestyle inflation refers to increasing one’s spending when income goes up. Lifestyle inflation tends to continue each time someone gets a raise, making it perpetually difficult to get out of debt, save for retirement or meet other big-picture financial goals.”

In other words, you can never escape the rat race. You are stuck working to simply pay bills without any chances to achieve financial independence. It’s a depressing situation.

What lifestyle inflation is not. 

It’s also worth noting what’s not lifestyle inflation with two very specific examples. 

• Increase in costs of living: if rent increases and you need to pay more to your landlord, that’s not lifestyle inflation. It’s just straight up inflation. The same goes with groceries and public transportation. On the other hand, if you move from a studio to a two-bedroom apartment all by yourself, that’s lifestyle inflation. 
• Primary needs: if you now make enough money to purchase health insurance, that’s not lifestyle inflation. It’s just being smart about basic necessities. Everybody should have health insurance in one form or another because if you don’t have one and become sick, it could bankrupt you. 

Avoiding lifestyle inflation

Avoiding lifestyle inflation is a necessity to achieve financial freedom. It’s important that when you receive a pay rise or a bonus, you don’t spend everything away. Unless you are satisfying an essential need, do not increase purchases and come up with a plan for that extra money. So if money is burning a hole in your pocket, then try the following tips to stay in control. 

Become aware of lifestyle inflation

It’s hard to become conscious of a problem when you do not know about. If you reached this sentence, then you know what lifestyle inflation is and you should be conscious about it. 

When I started my current job in London, I received a significant pay bump compared to what I used to be making. Sure, London is expensive and some expenses were bound to go up. But blowing up almost £7,000 in a month was clearly not a necessity. I upgraded my apartment, bought an expensive watch and completely failed at saving any substantial sums. 

It’s only when I started to discuss finances with some of my colleagues that I realized I far behind I was falling.

Once I became of the dangers of lifestyle inflation, I had to shake off two preconceptions that only encouraged lifestyle inflation. 

From then on, I took decisive steps to correct the situation.

“I can” does not mean that “I must”

Lifestyle inflation only becomes an issue when the increased income allows you to have more freedom. You think that you have available money to spend and therefore you naturally contemplate what you could spend that money on. And with so many choices available, it can be quite difficult to resist, even with the best of intentions. 

The issue I had was that I could essentially spend the money on whatever I wanted. Suddenly, I had the ability to go to the restaurants and never check the bill before paying. I knew I could do it so why not? The same reasoning applied to purchasing musical instruments or going on weekend trips. Soon enough, I would have more “goods” but at the cost of not making progress on more important investments such as buying a home. 

Once I realized that my savings were not increasing at least as quickly as my income, I took a cold-hard look at my spending habits and hit the brakes. To do so, you need to change  your mindset from “I can/I must” to “I could/I’ll wait.”

“I work hard so I deserve it”

If you have friends working for a big law firm in New York or London, then you know that their work schedule can be intense. The same applies to people working at prestigious investment banks. It’s not uncommon to regularly clock 70 hours a week with peaks at 100 hours. This is especially true when there are active transactions.

I’ve been there. You make more money than your friends who are teachers or journalists but the hours are objectively worse. It’s very easy to slip in the mindset “I work more so I should be entitled to enjoy myself a bit more.” This misconception is also known as “work hard, play hard.”

Again, you could do that. In the end, you will have little savings and possibly health issues due to a burn-out. Instead, enjoy the high-income salary by stashing half of it in a locked account to give yourself the freedom to live. 

Track your spending habits on a net basis

This will sound obvious but there is nothing like running the numbers on a piece of paper. 

Most people know that a £10,000 salary increase does not amount to a £10,000 lump sum that you can spend. There are taxes and national insurance/social security contributions that reduce disposable income. Part of your increase will also be absorbed by inflation: you will spend more just to keep the same living standards. 

Once you have deducted those costs, the amount you end up with is a lot closer to reality. That number is the theoretical disposable income gained from that salary increase. The amount of disposable income could easily be half the gross amount of your salary increase. Depressing? Don’t worry, everybody has the same conundrum. 

Chances are that by running the numbers, you will truly appreciate how much you gained and how much you have to spend. Realizing that the increase is not that significant on a net basis should make you think twice before splashing large sums of cash during your next visit at Selfridges!

Cover the basics first

What will you do with this new money? 

I find that one of the worst things in life is to have regrets. I’m talking about spending your money because “I only live once and money is meant to spent.” That’s true but there is a good way and a wrong one. 

The right way is to cover the basics first. Here are a few examples in no particular order:

• Contribute to your pension pot: if your pension contributions were lower than anticipated or did not match your expectations, it’s time to remedy this and boost the value of your pension. You know that your future self will hate you for not doing it.
• Spend to save money: it’s better to carry out repairs as soon as possible before the situation gets worse. If there is a leak in your bathroom, get it fixed now. If your car needs revisions, do it now. Those costs will not disappear overtime and dragging the issue could cause further damage, which could require more money to fix the same issue. 
• College fund: school is expensive. Students loans are a ticking bomb. Direct some money into a college fund or dedicated savings account. You might not have kids now but this cash will become handy sooner than you think.

The idea is to use that extra cash to cover some essential expenditures that you have so far neglected for one reason or another. 

When I started receiving a year-end bonus, my first step was to save the full amount. That was a good step and an improvement from spending everything! But I realized that I could fortify my financial situation by taking advantage of unused allowances for pension contributions and tax-free savings accounts. I also paid down expensive debt I had taken out to buy a car (which was a completely unnecessary purchase). 

Do not take more debt

Higher income means that you can take on more debt. Banks view you as richer and therefore your credit worthiness increases. 

Or at least, that’s the theory. 

In reality, taking debt will be a step back. You should not have too as you are now making more. Start by paying the most expensive debt and then build a cash buffer. The only debt you can take is a mortgage. And that’s only when you have at least a 20% downpayment and you stick to a reasonably sized-house (do not increase your budget to purchase a bigger home because you just got a pay increase). 

When taking on new debt, things can easily spiral out of control. First, few people actually take into account the interest costs and reduced cashflow in assessing the true impact of debt on a budget. Second, if you can truly afford something, with the exception of a house, you should be able to pay it cash. 

I made a few financial mistakes in the past but that’s one that I have always avoided. I never took a personal loan or increased my credit card spending because I could “afford it.” 

Gradually improve your lifestyle

It can be hard to stay motivated and to perform at work when you are not enjoying the rewards of your efforts. Paying debt and then saving are not particularly fun activities. 

While this is the right way to spend your cash, it should not result in undue pressure. You don’t want to feel so stressed about financial commitments and obligations that you just decide to quit and spend everything. In other words, you have to gradually release some of the pressure and indulge yourself moderately. 

This is where the balancing act can become difficult. A strict but solid rule of thumb is to spend money on an item if your pay increase is at least 10 times the amount that you intend to spend. Therefore, you should only buy the latest iPhone, which approximately costs £1,000, if your pay increase was £10,000. 

And this treat should only come once you have paid down debt and met your other financial obligations. 

More material things do not increase happiness

Good news, there is light at the end of the tunnel!

The older you grow, the higher your income, and the more you realize that your happiness is not a function of how much stuff you accumulate.

There is an enormous difference between making £25,000 and £200,000 a year. The difference from £200,000 to £400,000 does not provide you as much relief, happiness and sense of a purpose. 

Don’t try to prove that you are more successful or wealthy to your friends and neighbours by showing off and flaunting your expensive possessions. It just shows that you are unsecure, it attracts problems and it causes jealousy. A bad mix. 

As soon as you stop measuring your happiness and success in terms of purchased goods, you will experience a sense of relief. What matters is spending time with friends and family, being nice to other people and maintaining a good health. It sounds cliché but that’s what most people want. The few people who would rather take the money are likely to be ones thinking that they can buy those things. Unfortunately, they are very wrong.