What Is Lifestyle Inflation?
Lifestyle inflation is when you increase your spending as your income goes up.
In itself, lifestyle inflation is not a problem, but it becomes one when you increase your spending too fast relative to your income (excessive lifestyle inflation). It makes saving for retirement, repaying student loans or building an emergency fund much more difficult.
Because of lifestyle inflation, you may be living paycheck to paycheck even if you earn more than $100,000 per year. An unforeseen emergency like a job loss or a medical bill can have a huge impact on your life. Because of that, you are also likely to feel more stress.
Basically, excessive lifestyle inflation is what gets you stuck in the “rat race” and prevents you from achieving your long-term financial goals.
The one thing that will make you broke or keep you broke is excessive lifestyle inflation.
How We Start Inflating Our Lives?
When I was a student, I used to rent a room. When I needed to get somewhere, I walked or took public transport. I could live on very little and still have money to go out and have moderate savings.
However, it all changed when I got my first paycheck. I started thinking of all the things I could buy that I previously couldn’t.
The first thing I bought was a new smartphone. A couple of months later, I decided that public transport was no longer as fast and convenient, so I bought my first car. Things that were once luxuries had quickly become “necessities”, and my spending increased significantly.
It took me only 3 months to increase my monthly expenses to the level of my monthly income. At that point, I began my “rat race”. Even though I had read Rich Dad Poor Dad at the age of 14, I somehow managed to fall for the same trap a few years later.
What Causes Lifestyle Inflation?
Because of lifestyle inflation, a highly educated, high IQ, high salary person can have almost no savings and feel miserable. But why is that?
In general, the main thing that causes lifestyle inflation is living above your means! With each increase in income, you increase your expenses (usually on housing and cars) and believe that the additional goods or services will make you happier.
And living above your means is typically caused by the following 3 things:
#1 Entitlement
Entitlement refers to a general belief that you deserve more. You have worked hard for your money so you feel justified in splurging and treating yourself to better things. While this is not always bad, rewarding yourself too much can really damage your financial well being now and in the long run.
A friend of mine recently bought a car that costs 60% of her annual net income. She used all of her savings, borrowed money from parents and maxed out her credit card to make the purchase.
I remember talking to her before the purchase and she said: “I can’t find any car that costs less than $40,000!” I wasn’t surprised. She was looking only for cars that were less than 3 years old, had low mileage and were German brands.
Even though she is likely not to miss any payments due to a stable and highly paid job, it is hardly a rational decision. She already had a perfectly running car, but because she felt entitled to something better, the old car no longer seemed like a good option.
According to the RAC Foundation’s report on parking (see page 23), the average person’s car stands in the parking lot 96.3% of the time. Now think about it, is it worth spending a lot of money on something that you don’t use 96.3% of the time and it constantly loses value?
#2 Social Comparison
The social comparison refers to people comparing themselves to other people. We used to compare ourselves to our friends and co-workers, but social media and the internet have brought social comparison to another level.
Nowadays, we compare ourselves to our friends, celebrities and even random people that we find on the internet. We look at their perfectly curated images and often feel that our own accomplishments are not enough and that we need more, which can cause excessive lifestyle inflation.
Be careful, your wants can quickly become your “needs”!
Compare yourself to … yourself.
I could tell you many stories about how a friend of mine bought something on credit just because one of his friends had it. Worst case scenario is – they both bought something on credit that they cannot afford!
Next time when you are thinking of a big purchase, think twice. Are you buying because you actually need it or are you buying because of social comparison?
Comparison is the thief of joy! by Theodore Roosevelt
#3 Status Seeking
In general, humans are social creatures who intensely care about their relative status. They like to be associated with people and organizations that are powerful, important or exclusive. They also like to ensure other people are aware of their status. If you want proof, check your friends’ social media profiles.
Because of status seeking, people have a strong tendency to spend more if they have more. Things, like buying luxury brand clothing, expensive cars or watches and drinking VOSS water, are examples of showing your status, but they also result in lifestyle inflation.
One of the reasons for my early car purchase was to show my “success in life”. Which is a pretty stupid reason in itself. At the time, the car was out of my budget and buying it didn’t make much sense since I lived only 20 minutes away from my work using public transport.
The main thing that causes lifestyle inflation is living above your means!
The Negative Side of Lifestyle Inflation
Longer Road to Financial Independence
If you don’t save any money and your only “investments” are your house and your car, you may be forced to work harder than ever before. That’s because you keep increasing your expenses, instead of investing in income-generating assets.
That is the definition of a “rat race” – get more money, increase spending and continue this way. This pattern is usually controlled by fear and greed.
Because of this, you don’t have the flexibility to take some time off from work. You can’t risk quitting your job to start your own business. And most importantly, you don’t have a chance to build significant wealth since you are selling your time for money, which has very limited upside.
If you would put more money into income-generating assets or into your own education early on, your later years would be much better financially.
More Stress
Evolution has wired us to seek and prioritize short-term gratification. That usually requires spending and taking on debt today.
But inflating your life too quickly can easily result in a situation where you have a lot of debt and no savings. Hence, you are much more vulnerable to unexpected events, which naturally result in more stress.
Living below your means is considerably less stressful than constantly worrying about how you are going to make your car lease payments, mortgage payments and medical bills.
Also, according to the loss aversion theory, the pain of losing is psychologically twice as powerful as the pleasure of gaining. Therefore, it is better to inflate your lifestyle gradually so you don’t have to downgrade later on and feel the pain doing it.
I know from several people who had to massively downgrade their life after the 2008 financial crisis. Even now they can’t let it go. They often talk about how much they have lost and feel bad about it even though they are financially quite successful at the moment.
Rational saving gives you more satisfaction than irrational spending.
Strategies for Avoiding Lifestyle Inflation
The key is to upgrade your lifestyle gradually and always living below your means. Below are some strategies that will keep your lifestyle inflation low and stable (the list is not exhaustive), just like the governments aim for a 2% inflation.
#1 Live Below Your Means
Not every dollar from your bonus or salary increase needs to be spent or invested ASAP. Take your time before making a purchase, especially when buying a house or a car. These two items are the most dangerous when it comes to lifestyle inflation.
#2 Be on Top of Your Finances
First, you have to make sure that your income exceeds your expenses. Then, create a simple budget to see how much of discretionary income you have each month. Part of your discretionary income should go to your emergency fund and the rest can be invested or spent on your hobbies. Make sure that you don’t invest your money in depreciating assets or inflate your life too much and too early.
#3 Avoid Debt
If you want to buy something expensive, think of ways to increase your income rather than buying something on credit. Deep down you know that if you can’t pay cash for something, you can’t afford it. Each monthly payment will be a reminder of how stupid you were with your money.
#4 Find Cheap Hobbies
Golf, racecar driving or yachting will only increase your lifestyle inflation and you will always feel stressed about maintaining your income level. Instead, you can pick up cheaper hobbies, which give you the same amount of joy. Some of my favourites are – hiking, reading, barbecuing and geocaching.
#5 Don’t Move to the Best Neighbourhood
A great example can be found in Nassib Taleb’s book Fooled by Randomness, where he wrote: “You get rich, then move to rich neighbourhoods and then become poor again.” This is about how social comparison affects your thinking and makes you feel like a failure among people who are richer than you. As a result, you feel more stress and are likely to spend even more money to elevate your social status.
#6 Be Aware of Human Psychology When Making a Purchase
You read above how entitlement, social comparison and status-seeking can affect your decision-making. I know many people that have purchased expensive things they didn’t really need and couldn’t afford just because of these reasons. Even I have done it in the past.
#7 Understand the Opportunity Cost
For example, buying a new TV might seem like a good decision. But what is the opportunity cost for you?
First, it’s your money. You have spent your money on a depreciating item that consumes even more money (electricity, speakers, Netflix etc). Instead, you could have invested in your skills, appreciating assets or kept it as savings that give you peace of mind.
Second, it’s your time. The main problem is that watching TV gives you only short term pleasure. If I asked you after watching TV series for 4 hours straight if you consider that as time well spent, what would you say? Probably – no! In this case, the opportunity cost is the time that you could have spent on more meaningful activities, such as learning a new skill, developing a side hustle or hanging out with your friends.
#8 Make Gradual Changes
An expensive car might require an expensive mechanic, a new gadget might tempt you to buy another gadget and a big house requires more upkeep. Don’t go “from zero to 60” immediately after you get a bonus or increase your income. Celebrate modestly and pat yourself on the back.