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Today we are going to talk about lifestyle inflation and why conventional advice leads us directly into it. This is the first in a multi-part sequence to help you fundamentally change how you think about your savings and net worth. Warning, there be numbers ahead.
Let's start with a basic piece of personal finance advice we hear: save 10% of your income. This doesn’t seem too hard and at first glance, manageable for the majority.
But what happens if we think a bit more about that advice? If you are like most people, saving 10% of your income seems to imply spending the other 90%. As we all know, having money burns a hole in your pocket, just waiting to be spent. Few people manage to save extra by accident.
It's this little fact, the spending, that creates the lifestyle inflation trap even though we may have good savings intentions. Let's walk through an example.
Example Scenario:
Let's say you make $50,000 a year. For the sake of the scenario, this is after-tax. You save 10% each year ($5,000) and spend the remaining 90% ($45,000). After 9 years, you have saved $45,000. Nice! But, this amounts to just one year of your spending.
Now you get a huge raise and you make $100,000 per year. You keep up your saving habits and are now saving $10,000 a year. Awesome! With the rest of your new money, you decide to upgrade your life. Why wouldn't you? You have already done the responsible thing and saved 10%, doubling your annual savings each year.
You are now spending $90,000 a year. At the end of the year, your savings are now $55,000. But with your new spending habits, those savings are now only worth about 60% of one year's spending. You managed to backtrack because of your raise!
We were told to save 10% a year! Unfortunately, when you make more, by following this advice you will also spend more. And when you spend more, your savings become worth less. And to think, this devaluation of your savings is happening every time you get a raise.
This is the problem with thinking about your savings as a fixed dollar amount, but I'm getting ahead of myself. That's a concept for next time.
If it sounds like the answer for this is "spend less", that's the approach, but it's misguided to take it at face value. Your goal is to actually increase your % of savings with each raise, requiring a bigger jump in saving each time.
Here is a tip to start:
Instead of upgrading your lifestyle with monthly expenses (car, rent, regular dining), treat yourself with one-time purchases after your raise. A vacation, a new phone, or a short shopping spree (depending on the size of the raise). While this may sound unconventional, it's a one-time purchase instead of a change to your recurring monthly expenses.
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