So often, people watch their careers flourish and their incomes grow – but no matter how fast they do, somehow their overall financial situation seems to go nowhere. Sometimes, it even gets worse. How can that be? It’s called lifestyle inflation, a kind of financial cancer that can render your finances a complete wreck, even as your career takes off.
It’s important to realize that income and net worth are not the same thing. Income is how much you make, but net worth is what you’re left with after all your living expenses are paid. If those expenses are too high, you will never see your net worth rise – and your finances improve – no matter how high your income is. That’s what lifestyle inflation does to your finances. And it’s something we all need to be on the lookout for.
What is Lifestyle Inflation?
Lifestyle inflation has become so pervasive that it even rates a dedicated definition from Investopedia.com:
“Increasing your spending when your 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. Lifestyle inflation is what causes people to get stuck in the rat race of working just to pay the bills.”
That’s the general idea. On a mechanical level, lifestyle inflation looks like higher living expenses, more debt, and very little in savings and investments. You’re in the trap if that combination remotely describes your financial situation.
How Lifestyle Inflation Overwhelms Your Finances
Lifestyle inflation is virtually a default setting. Unless you’re intentional about managing your finances, your living expenses will continue to grow, eating up every extra dollar you earn and sometimes even more.
Have you ever played that game what would you do if you had $1 million? There are different versions of that question, but it comes down to what would you do if you suddenly came into a very large windfall of money? It’s fun to imagine, but if you listen to the answers that most people give you begin to get a solid idea as to how dangerous lifestyle inflation can be.
When confronted with the prospect of coming into a large amount of money, people almost instinctively read off a laundry list of how they would spend the money. Very few ever contemplate how they might save and invest it. In reality, this is what often happens to people who win the lottery or inherit a large amount of money. In short order, they end up broke.
That’s the essence of lifestyle inflation. We all have an almost limitless number of wants in life, and when the money becomes available those wants are magically converted into needs. The difference between wants and needs is more than just semantics. Wants are something that we would like to have – needs carry a certain urgency. The transition from wants to needs often happens as a result of a pay raise, a promotion, or the receipt of a windfall.
The Worst Part – You Don’t Even Know It’s Happening
Most times, you won’t even recognize that lifestyle inflation is taking place. That’s because the whole concept is rooted in emotion, rather than logic.
Let’s say that you get a $10,000 increase in pay. $3,000 will go for income tax and payroll deductions, so you’ll really have only $7,000. You reason that this is the perfect time to replace your old clunker with a brand-new car. You then go from no car payment, to $400 per month. But what the heck, with a big fat raise swinging the monthly payment should be no problem, right?
There’s a good feeling that comes with having extra money. So in addition to buying yourself a new car, you also increase your eating-out from once per week to twice, at an extra $50 per week. You also decided you need to new clothing, and about $1,000 should do it.
Let’s add that up. $400 per month a new car payment comes to $4,800 per year. The extra restaurant meal per week at $50 each comes to $2,600 per year. And then there’s the $1,000 for clothing. $4,800 plus $2,600 plus $1,000 comes to $8,400! Not only does that combination eat up your entire $7,000 net increase in pay, but you’ve also overspent.
Making more money feels good, and that’s the problem. When you feel good, your defenses are down and you enjoy the extra financial freedom. Since it quietly, gradually goes into consumption, none of the extra income ever makes it into the bank.
That’s how lifestyle inflation creeps into your life, and keeps you from ever getting ahead financially.
Preventing Lifestyle Inflation From Happening
It’s easy to see lifestyle inflation happening in the lives of other people. But it’s more complicated when we’re engaging in it ourselves. If that’s been your pattern in the past – and the evidence will be inflated credit card balances and an undersized bank account – you’ll have to take concrete steps to get it under control.
Try these steps to get out of the lifestyle inflation trap, and put you on the path to financial independence:
- Track your spending – make sure you know exactly where your money goes
- Reduce or eliminate any expenses that are not absolutely necessary
- Set up payroll savings plans; you can direct money into a savings account, mutual funds, and of course retirement plans (yes, even IRAs if you don’t have an employer plan)
- When ever you get a raise, increase your payroll savings by the amount of the net pay hike
- When ever you get a cash windfall, use it either to payoff debt, or to put into savings and investments – don’t give yourself the opportunity to spend it on something you don’t really need
Unfortunately, lifestyle inflation can easily become a way of life – it is for millions of people. Breaking out of that habit will be like going on a diet, except that this one will be a financial one. That means that it will be painful at first, but once you get control of your finances, your life will get progressively easier. It’ll will be like creating a new automatic pilot for your life, one that will stack the long-term deck in your favor.
