Most people will spend more money if they have more money to spend. Consider a college graduate who, just embarking on their career, settles into a comfortable apartment for $750 a month. A couple of years later, their salary has increased, so they find a “better” apartment for $1,250 a month. The old apartment was adequate—good condition, great location, nice neighbors—but the new one is located in a more exclusive neighborhood. Despite the fact that the original living arrangement was fine, they traded up to a more expensive apartment—not because they needed to, but because he could.
When a person advances into a more profitable position at work, their monthly expenses typically rise correspondingly. This is a phenomenon known as lifestyle inflation, and it can present a problem, because even though you might still be able to pay your bills, you are limiting your ability to build wealth.
Why Lifestyle Inflation Happens
People have a strong tendency to spend more if they have more. A couple factors are at work here. One is the “keeping-up-with-the-Joneses” mentality. It’s not uncommon for people to feel like they have to keep up with their friends’ and business associates’ buying habits. If everyone drives a BMW to the office, for example, you might feel compelled or pressured to buy one as well, even if your old Honda Accord gets the job done just fine.
Likewise, your house on one side of the city may have been your dream home when you moved in, but with so many of your colleagues talking up life on the other side of the city, suddenly you may feel the need for a new address. Lifestyle inflation creeps into more areas than cars and homes— you can also end up spending more money than you need to (or should) on vacations, dining out, entertainment, boats, private school tuition, and wardrobes, just to keep up with the Joneses. Keep in mind that the Joneses are typically servicing a lot of debt over a period of decades to maintain their wealthy appearance. Just because they look rich doesn’t mean they are and doesn’t mean they are making financially sound decisions.
Another contributing factor to lifestyle inflation is entitlement. You’ve worked hard for your money so you feel justified in splurging and treating yourself to better things. While this is not always a bad thing, rewarding yourself too much for your hard work can be detrimental to your financial health now and in the future.
Spending More Makes Sense – Sometimes
There may be times when increasing your spending in certain areas makes sense. You may need to upgrade your wardrobe, for example, in order to be dressed appropriately at work following a recent promotion. Or, with the birth of a new baby, you may really need to move into a house with an additional bedroom so the grown-ups can get some sleep. Your situation will change over time—both professionally and personally—and you will likely have to spend more money on things you previously avoided altogether (like a car) or things you could skimp on (like your wardrobe). A certain amount of lifestyle inflation is to be expected as your work and family obligations evolve.
Spending a little extra to improve your quality of life might also make sense—as long as you can afford it. As you advance in your career, for example, you may not have time anymore to mow the lawn and clean the house—unless you use your one day off to take care of such chores. Even though it’s an added expense, it’s reasonable to spend the money and pay someone else to do it, so you can free up some time to spend with family, friends, or doing a hobby you enjoy. Being able to enjoy a bit of free time helps promote a healthy work-life balance and can make you more productive at work.
Avoiding Lifestyle Inflation
While some level of lifestyle inflation may be unavoidable, remember that every spending decision you make today affects your financial situation tomorrow. In other words, that $800 pair of Jimmy Choo heels you just bought is coming straight out of your retirement nest egg. Can you afford to spend that much on shoes? Even if you can, should you?
Even with a substantial pay increase, it’s possible (and quite easy) to end up living paycheck to paycheck, just like you did when you were making much less money. That’s because the increased spending that results from lifestyle inflation can quickly become a habit: the more you earn, the more you burn. You buy more things than you need just to maintain your new (inflated) standard of living.
Assume you splurged and bought that $800 pair of Jimmy Choos when you were 25 years old. Imagine you had invested that $800 instead. When you reach age 65, your $800 would be worth $5,632, assuming no additional investment and a 5% interest rate return. Even though the shoes are awesome, would you rather have great shoes for a couple of years or almost $6,000 extra entering retirement?
Source : Investopedia