What did you do when you received your first paycheck after graduation? Did you put it in a savings account? Go out for a celebratory meal? Maybe start building an emergency fund?
Everyone reacts differently to new income when they leave college. But there is one thing you should avoid every time you see your income increase: lifestyle inflation.
1. Beware Lifestyle Inflation
Lifestyle inflation is an increase in spending on day-to-day living expenses as your income increases over time. Sometimes it happens all at once when you receive a pay raise. Other times it is a gradual change that you hardly notice.
A pay raise is an opportunity to increase your savings for major purchases in the future, like a home or car. It’s also an opportunity to increase your investments in a 401(k) retirement plan or Roth IRA retirement account. You can even use it to pay down your student loan!
However, be careful about using your pay raise to get a fancier apartment or to have more expensive nights out with friends. You may be robbing your future self of money you might have a better use for down the road.
It is okay to have a celebration when you get a raise or treat yourself to something nice. But make sure it is a one-time expense, not a habit.
2. Avoid Lifestyle Inflation Before it Starts
Let’s say you’re living great on $45,000 a year, and you get a salary bump to $49,000. You now have $4,000 more per year to do whatever you want with, minus the taxes that are taken out of course. You could get a new car, head to the mall for a “treat yo self” spending spree, or blow the money elsewhere.
Or, even better, you can keep living on the $45,000 per year you are used to and put away that $4,000 raise for the future. The best way to do that is by using automatic savings and investing, so the $4,000 never comes into your checking account to tempt you.
Depending on your situation, you might want to increase your 401(k) contribution and stash the raise tax-free. Or, you could split your direct deposit to have a portion go into a Roth IRA to help you reach the annual maximum.
You can also split your paycheck multiple ways. You could have a portion go to a high-interest savings account and increase your emergency fund. Simultaneously, another portion could be used as a down payment for a home.
If you can automate it, you will save and invest without having to think about it. With this setup, you can’t mess up and accidentally spend the money elsewhere. You will keep getting the same paycheck you were before, so you can maintain the same lifestyle no problem.
3. Find the Right Balance
Sometimes putting 100% of your raise into a savings or investment account doesn’t make that much sense. That’s okay. It’s your money, you’re the one who gets to decide how to use it.
If you live in a crappy apartment, it may make sense to pay a little more to live in a better one. If you’re on the ramen diet, by all means, use the money to buy better, healthier groceries. If your clothes are falling apart, you may be due for a whole new wardrobe.
The key is getting the best bang for your buck where you can improve your lifestyle without spending too much more. Maybe you get that $4,000 raise and decide to keep $3,000 for savings and allocate $1,000 for living expenses. That’s great, as long as it is a conscious decision.
Whatever you decide to spend your money on, make sure it doesn’t get sucked up by unintentional lifestyle inflation. You don’t want that $4,000 raise to go 100% towards entertainment, hobbies, and expensive designer outfits.
4. Reverse Lifestyle Inflation
If you are well into your career and are reading this article thinking, “Oh man, it’s too late for me,” don’t worry. You can undo some of that lifestyle inflation by taking calculated, slow steps.
First, look at your budget and where your money is going today. Are you spending regularly on fun activities that you could reasonably live without? Do you go to the movies weekly? Maybe you have an expensive hobby or a bunch of subscriptions for services you could do without.
These are common expenses where you can save a little money. There are plenty more places you can look to trim your spending as well. You just have to take a hard look at your budget and confront your unnecessary spending.
Once you have identified the places you are going to save money, make the savings automatic. You can use a split direct deposit or increase your 401(k) contribution.
You could also set up an automatic recurring transfer and move money from your checking to your savings on payday. That way, you are never tempted to spend that money.
5. Use the Money for Long Term Goals
If you are lucky enough to get a new job or a raise that increases your income, remember to “pay yourself first” before you spend that money. Focus on paying off your student loans, saving for a home, and investing for retirement.
Don’t squander the opportunity to set yourself up financially later. Help yourself in the long-run by saving regularly with each pay increase, and you’ll successfully avoid lifestyle inflation altogether.
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