Costs tend to creep up, if you take no actions

Almost every household is confronted with that phenomenon: Lifestyle Inflation. It means that costs climb with income (for instance after a pay rise), all too often disproportionally.

What’s the problem with Lifestyle Inflation?

Well, it decreases the profitability of a household.

There is nothing wrong per se with consuming and enjoying an increasing salary, but there’s a flipside as climbing spendings often go hand in hand with a massively growing fixed cost block. This means people build up cost positions they cannot scale back in the short term.

For instance

• renting a larger apartment leads to a higher rent
• and higher costs for house insurance
• as new furniture is bought etc.

The list goes on an on, and fixed costs are adding up really fast.

Fixed costs are to the detriment of the financial fexibility and stability of a household.

People tend to focus on discretionary spendings, such as going out to restaurants every week. These cost positions are low hanging fruits when someone wants to cut spendings to save money.

But let’s look at the fixed cost block and think about that: how fast could you slash your spendings for your rent and insurances if you lost your job or earned substantially less from one day to another? It could easily require months, even a year, to adapt your cost structure.

Eroding profitability of a household due to Lifestyle Inflation enhances its risk position and makes people stuck in a rat race having to work more and more just to pay their bills.

Lifestyle Inflation happens often slowly, over time, it’s a creeping process.

So how to tackle lifestyle creep and increase your financial shape?

• First, track your spendings and your savings rate each month.
• Know exactly each cost position, in particular the fixed costs such as rents, insurance costs etc.
• Make a plan on how to keep the fixed cost block as low as reasonable and possible.
• Start a virtuous circle by investing the savings into quality assets to establish passive income streams, which boosts your household’s profitability further.
• Focus on your household’s bottom line and consequently increase your savings rate over time
• Get familiar with the concept of Jaws Ratio and apply it on a regular basis.

It’s possible to keep Lifestyle Inflation at a minimum if you are conscious of that effect and take action. Many good things happen in a financial sense if you hold costs steady (or only marginally increasing) while boosting your income. You gain a whole lot of flexibility in life, and with consistency, patience and hard work, achieving Financial Independence becomes a viable option.

Focus not on the salary but on your savings rate

It was a few years ago that I followed a conversation between two guys, one of them planning to buy a house for USD 1 Mio in a rural area.

That guy told his friend, that the down payment would be USD 250’000 and that he had saved that amount during the last 10 years.  He said that his nest egg surpassed at least his “spending budget” of one year.

As the conversation went on, the future home owner said that – considering his high salary of USD 300’000 annually – his bank better offered him an attractive interest rate for the mortgage. After all, he added with a wink in his eye, he was now a millionaire.

That conversation showed a general misconception many people have on wealth and income.

Wealth is what you accumulate over time, not what you earn. The key factor in the process of wealth building is the saving rate. A high salary does not automatically translate into substantial wealth.

Now take our home owner. His gross salary was somewhat above USD 300’000 per year as he told his friend. And yet his wealth increased by a relatively small amount of about USD 25’000 per year.

It’s very obvious, that a massive portion of his job income had been eaten away by his spendings each month. High paid jobs in particular tend to accentuate the effect of Lifestyle Inflation.

Who’s the owner of your house?

The purchase price of a house in the amount of USD 1 Mio. does not mean the home owner is a millionaire. Yes, real estate prices tend to appreciate over time. But that’s not always necessarily the case.

Looking just at the numbers in our example and just assuming there were no other assets and no capital appreciations, his net worth – which is the difference between assets (market value) less liabilities would be USD 250’000. Considering his savings rate of about 10 %, the accumulation of USD 1 Mio. would have taken that homeowner decades.

Many people earn far less and manage to accumulated that amount in a relatively short time period just by consistently keeping a high savings rate.

And here comes a really crucial point: taking on high liabilities (with regard to one’s usual annual savings) tends to make people stuck. They get dependent on a regular, high income work. They depend on their jobs.

So, the key is to be constantly aware of such effects. To know that we live in a consumerism world, that automatically leads to Lifestyle Inflation. It’s considered as normal, but it’s not. It’s not natural. It puts people in a Rat Race.

Take actions in order to

• avoid the bank being the main owner of your house and
• most importantly: don’t allow your employer being the owner of your time.