Updated: Aug 16, 2020
When most people think about the things most likely to destroy their wealth, they think about taxes, divorce, and unexpected medical bills. While it is true that all of these have the potential to significantly diminish your wealth, there is another destroyer of wealth that does not get talked about enough.
I am talking about lifestyle inflation.
Lifestyle inflation is the phenomenon of your spending increasing at the same pace as your income, preventing you from saving more money.
An event like a divorce can be devastating on your wealth. If you lose half of your assets in a divorce, that has an obvious impact on your wealth. It is also a clear risk that we can identify and plan for because it is an event.
Lifestyle inflation, on the other hand, is not an easily identifiable event. It is much more subtle because it influences our everyday decisions. The impacts of lifestyle inflation can seem small at first, but little by little, the impacts compound, making it one of the great killers of wealth in the long run.
Let’s discuss what lifestyle inflation is, how it impacts your ability to build wealth, and, most importantly, how to avoid lifestyle inflation.
What is lifestyle inflation?
Your boss calls you into his office and tells you that you have been promoted. You’ll be getting an impressive title, a corner office, and of course, a big-fat pay raise. Upon hearing this news, you go back to your desk and start making plans to buy that sports car you have always dreamed of owning but couldn’t afford until now.
That is lifestyle inflation.
Put in the simplest possible terms, lifestyle inflation refers to the phenomenon of your cost of living increasing alongside your income. As more money goes in, more money goes out.
It seems harmless, and after all, why shouldn’t you enjoy some of the finer things in life when you get a raise? It’s very easy to tell ourselves that we have worked hard and deserve to own fancier, more expensive stuff.
The truth is that lifestyle inflation is one of the great destroyers of wealth and is the reason that many “rich” people are broke.
Making a lot of money does not make your rich
Many people believe that making a lot of money means you are rich, while I can understand why someone would think that people who make a lot of money are not necessarily wealthy.
There are plenty of people who make six-figure incomes that appear to the outside world to be wealthy. They drive an impressive car, live in a McMansion, wear designer clothes, eat at expensive restaurants, and go on lavish vacations.
These people appear to have it all. But you might be surprised at how many of these “rich” people are living paycheck to paycheck. The ultimate measure of personal wealth is how long you would be able to maintain your current lifestyle if you stopped getting paid.
By that measure, a family making $75,000 per year, could be wealthier than a family making $750,000 per year.
A family that makes $75,000 per year and has managed to save $90,000 would be able to go three years without a paycheck if they are only spending $30,000 per year.
A family that makes $750,000 per year and has only managed to save $90,000 wouldn’t be able to go three months without a paycheck if they spend $450,000 per year.
Wealth is not about how much money you make, it’s about how much money you hold onto.
The consequences of lifestyle inflation
To some, lifestyle inflation may not sound like such a terrible thing. You may not be saving much money, but you can continue to increase your standard of living over time. As long as you have a paycheck coming in every two weeks, you won’t feel the consequences of lifestyle inflation.
The bill comes due once those paychecks stop. You might wave that away by saying, “I love what I do. I could work forever.” This statement usually comes from people who are relatively young and healthy. You may not feel the same way when you are old.
Let’s assume that if you could, you would love to continue working for the rest of your life. There is one major problem that remains, the decision to work will not always be yours to make.
At some point, your health or the state of the economy may prevent you from working. When one or both of those events happen, you feel the devastating consequences of lifestyle inflation.
That’s what happened to my family.
How lifestyle inflation impacted my life
My parents were both realtors, they were one of those husband and wife realtor teams. Mom handled the paperwork, and the business side, Dad was the sales guy.
When I was a little kid, we lived in a set of flats, and my brother and I shared a room. It wasn’t a huge house, but we were comfortable and perfectly content. I had never lived anywhere else, so while it was annoying sharing a room with my older brother, I had no point of comparison.
My parents became more successful, even winning sales awards in real estate. When I was 12, they made the decision to move out of the flats and buy a massive house.
If I were to pinpoint a single decision where things went south, that would be it.
The house was old and needed massive renovations. An old house also means higher heating and utility bills. It was a beautiful home, and I have countless fond memories of living there, but between the mortgage, taxes, maintenance, and utility bills, it was a real money pit.
The increase in living expenses did not stop there.
The family traded in the reliable station wagon in for a series of older luxury cars like BMWs and Mercedes. When a 20-year-old Mercedes-Benz breaks down, things get expensive.
Lifestyle inflation was no big deal because, as I mentioned, my parents sold a lot of houses.
Then 2008 happened.
The financial crisis was not a good time to have 100% of your income dependent upon selling houses. Especially if you have no savings multiple mortgages, and maxed out credit cards.
My parents declared bankruptcy, and we lost the big house within 10 years of moving into it.
The next five years were tough on all of us, and on many occasions, I had to extend my own personal line of credit to help my parents pay the bills.
If you have young kids and you think you are doing them a favor by moving into a bigger house, buying them loads of presents or going on big vacations, you are not. At best, it distorts their view of money. At worst, it could set up a chain of events where you put them in a position to support you financially, potentially at a very young age.
It’s not hyperbole to say that lifestyle inflation and it’s hideous consequences fundamentally changed who I am as a person and made me obsessed with money and how to properly manage it.
The psychological trap of lifestyle inflation
If you want to avoid falling into the trap of lifestyle inflation, it’s useful to examine its root cause. There are endless excuses (and I have heard a lot of them) that people would use to justify their overspending. It all boils down to the simple need to project a certain level of social status.
When you look at the big-ticket items that people overspend on, you will notice that they are all visible expenses.
Lavish vacations (with lots of pictures for the Gram)
Jewelry and watches
All of these expenses scream to the world, “look at me, I made it!”
The original term for this need to spend to impress was called “keeping up with the Joneses.” If your neighbors, let’s call them “the Joneses,” bought a brand new BMW, you might start looking at your 5-year old Toyota in the driveway and begin to feel a bit insecure. Maybe that causes you to go out and buy a new car that is just as nice or even better than your neighbors BMW.
The sad reality is that we all have a natural tendency to compare ourselves to other people. A paper written by Ada Ferrer-i-Carbonellin published in the Journal of Public Economics found that people’s happiness and sense of self-worth are equally impacted by two factors.
How much money they make.
How much money the people around them make.
People who know that they make more money than their friends and neighbors are the most likely to feel successful with money. This is referred to as “social comparison,” which is the route cause of lifestyle inflation.
Social media spreads lifestyle inflation like wildfire
If you didn’t know that your friends and family had more money than you do, the odds are you would feel better about your financial situation and would not feel the pressure to give in to lifestyle inflation.
The solution should seem pretty obvious then, focus on your finances and don’t worry about what everyone else is doing. Unfortunately, in the era of social media, that is close to impossible.
Most people use social media to paint themselves in the best possible light. If you were to scroll through most of your friend’s Instagram feeds, you would find pictures of them on epic vacations, eating at the best restaurants and dressed to the nines. What you would not see is pictures of them eating in front of the TV with a mustard stain on their shirts. Even if the mustard statin is more representative of their day to day life.
People also use social media to make themselves look more financially successful than they really are. No one wants to broadcast that they have three maxed out credit cards and are living paycheck to paycheck. Instead, they post pictures that give the impression that they are wealthy and successful. A report called “The Secret Financial Life of Americans” found that 28% of Millennials admitted that they intentionally try and make themselves look wealthier than they really are through social media.
This is where social media amplifies social comparison and pushes people towards lifestyle inflation. When you see pictures of people you know, who appear to be so much more successful than you are more likely to feel worse about your financial situation. If you see a picture of your buddy Bryan on a beach in some exotic destination, you are more likely to feel the pressure to book your own trip, even if you can’t afford it. Then it’s your turn to post some “epic” picture that will cause your friends to feel like they are missing out or failing somehow.
Social media makes us all feel miserable and pushes us to spend money we don’t have on things we don’t need.
We have established that lifestyle inflation is the process of increasing your cost of living as your income increases. We have also established that it can prevent you from saving money and building financial security.
There is something much worse than lifestyle inflation, which I will call lifestyle hyperinflation.
Lifestyle hyperinflation is the process of increasing your standard of living without increasing your income.
Social comparison and the urge to keep up with the Joneses is not exclusive to people who are getting pay raises every year. People making minimum wage have these same feelings. Those who make the least money are just as human as those who make six-figure salaries and have the same emotional reactions.
There is only one way someone can continually increase their standard of living without increasing their income; they borrow money.
Putting that extensive birthday gift on a credit card.
Borrowing money from family and friends to pay for the family vacation they “need” to go on every year.
Using the equity in their homes as a piggy bank.
Lifestyle hyperinflation is how people fall down the debt spiral where bankruptcy and financial misery await.
Debt is not evil or destructive. It’s how we use debt that can make it feel evil and have destructive consequences.
Borrowing money to buy a house, get an education, or start a business can be an extremely positive decision with the potential to improve your life.
Borrowing money to go on vacation, buy a second car, or pay for Christmas gifts is how people fall into financial ruin.
How to end the destructive cycle of lifestyle inflation
Lifestyle inflation is a psychological problem and requires a psychological solution. This is not something you can fix with a spreadsheet.
The lure of lifestyle inflation is always present; you simply need to fight against its pull. That’s why you need a strong, confident mindset to win the daily battle with lifestyle inflation.
The first step to building a strong money mindset is to have a “why;” A motivation that is more powerful than the temptation to give in to lifestyle inflation.
My “why” ”has always been my family.
At first, it was to help my parents. The years that followed their bankruptcy in 2010 were incredibly difficult for everyone in the family. They needed my help to get back on their feet. Helping them do that was far more important than going on vacation or buying a new car.
Today, my “why” is my son. I have a photo of him on the desktop of my computer. The title of the file is “my-why.” I look at that picture multiple times a day, and I never feel the pull towards lifestyle inflation. Knowing that the decisions I make with money today will set him up for a great life in the future brings me more happiness than anything I could buy.
If you find the right “why” you will be able to resist the pull of lifestyle inflation.
What to do when you get a pay raise
Here’s a simple trick you can use to ensure you never fall victim to lifestyle inflation.
The next time you get a pay raise, work out how much more money you will clear on every paycheck, and set up an automatic savings plan for that money. For example, if you got a pay raise that would increase your take-home pay by $100 every two weeks, you would call your bank and set up an automatic transfer into a savings account every two weeks.
When I say savings, this could be for many things.
Saving for an emergency fund.
Paying off debt.
Saving for your child’s education.
The most important thing is that you automate the process. It takes the decision out of your hand and guarantees that you don’t fall victim to lifestyle inflation.
Finding the right balance
You might be thinking that this sounds pretty boring. Do you really have to save every pay raise for the rest of your life?
Of course not.
Once you are debt-free, have a fully-funded emergency fund, and are saving enough to retire at the age you would like, then you can slowly start spending more of your money. Maybe at this point, you start saving only half of your raise rather than the whole thing.
Each of us has to find the balance between achieving our financial goals spending our money on the things we truly value in life. The most important thing to remember is that when you do spend money, make sure it is for the right reason and never spend money to impress other people.
Keeping lifestyle inflation in check
Remember, a high income does not make someone wealthy, and a low income does not make someone poor. It is about what you save, not what you make. That is why it is crucial to keep lifestyle inflation in check.