Working towards financial independence requires us to bring in an income and then utilising it in a way that can generate further wealth. The aim is for that wealth to reach a point where it can sustain us for the rest of our lives, meaning we no longer need to actively trade our time for money in order to keep living our lifestyle.
For the majority of people this means working to earn a salary and then taking the amount you can save to invest or leverage into an asset that can help you make progress.
Here's a familiar equation:
Earnings - Spending = Savings Rate
For those of you who voraciously consume material around the FIRE movement you will no doubt have come across Mr. Money Mustache's article on The Shockingly Simple Math Behind Early Retirement that explains the math, and if you haven't then I highly recommend you place it onto your to-read list.
To put the results of MMM's findings into a sentence, the higher your savings rate the sooner you can retire. But here's a question:
Does earning a higher salary mean you will reach financial independence quicker?
The answer might seem like an obvious "yes" because you'll probably think that the more money you have coming in, the more money you can save. But sometimes "saving more money" doesn't actually help.
Some basic math
To help make this clear I'm going to need to dive a bit into the numbers to explain what I'm talking about, so here goes. Let's imagine two scenarios where you're earning and spending money, and this is calculated into percentages:
Just by looking at these percentage rates you can easily tell that you would reach financial independence much quicker in Scenario A, due to the higher savings rate.
If we apply really straight forward "math" to Scenario A we can work out how long it takes to save up enough money to cover one year's worth of essential and non-essential spending. You can do this by simply dividing 60% of spending (45% + 15%) by 40%:
(45% + 15%) ÷ 40% = 1.5
So in one and a half years of saving you'll have enough money to cover essentials and non-essentials for a year.
In contrast to this, for Scenario B you need 19 years of savings (5%) to cover 1 year of essential and non-essential spending (35% + 60%):
(35% + 60%) ÷ 5% = 19
Note: This isn't quite how the math should be applied but it gets the point across, the less you save the longer it takes to build up enough money that can cover your outgoings.
Notice how actual earnings or spending figures are not needed. You could be earning double or triple the amount in Scenario B, but due to your spending habits it would still mean the goal of financial independence is not a near term prospect.
This goes to show that the rate at which you approach financial independence is only partly dependent on the amount of money you make. The bigger part of the equation is due to your own actions on how you use the money.
But all of this is obvious; I’ve basically just said the more you spend the more money you need. So why mention it?
It’s important to mention because while the equation and theory is obvious, the effects of lifestyle inflation are often not.
Lifestyle inflation is where you gradually increase the amount you spend due to increased earnings that you might be bringing in, possibly from a raise in your salary or even from an extra income source. Alternatively, it might be an increase in spending that has been caused by what you see other people are buying.
You notice two neighbours buying new cars and that causes you to start browsing the car market. After seeing a car that you quite like you take a look at the price and maybe the various payment options; eventually you run the numbers through your budget and it turns out that the extra income you have from your recent pay rise is just enough to cover the car payments. As you feel like you can justify it in your budget and since everyone else is buying a new car you decide to make the purchase; welcome to the neighbourhood new car club.
But you didn’t need or want a new car in the first place. The only thing you’ve done in this situation is waste some of your money which could have gone into making progress on your journey towards financial independence. You’ve effectively delayed yourself as you've spent some of that progress, and it will now take longer to get to your goal.
Ironic how buying a vehicle has made the journey even longer.
It doesn’t even have to be a relatively big purchase, it can be something small but consistent over a long time. Let’s say you got a raise and now you have a little bit more "spending power", what can you do with it?
Putting it towards your investments to further build your wealth will be the obvious smart choice and it might even be the first thing that comes to your mind. After all, you've earned a raise so you should reward yourself and rightfully so.
So you decide that you’ll put some of your raise into your investments from now on (excellent decision), but you will also spend some on the non-essentials to improve your lifestyle. Win, win right?
Let’s calculate it using the following numbers:
Before getting a raise you were earning a total of £1,000 and putting £300 away each month into your Savings & Investments, giving you the following savings rate:
£300 ÷ £1,000 = 30%
After getting a raise you begin to earn a total of £1,300 each month, which is quite a nice bump up in terms of your income. You decide to make a smart move by increasing the amount you put into your Savings & Investments, and 25% sounds like a fairly sizeable amount to go for. That would mean you're putting an extra £75 on top of the original £300 each month, bringing the amount to £375.
However if you do the math on these new numbers you will get the following savings rate:
£375 ÷ £1,300 = 28.8%
As you can see, despite increasing the amount you put into building your wealth by 25% your overall savings rate has gone down slightly due to the increase in spending in other areas. This means it's going to take longer for you to reach financial independence, despite earning quite a bit more money than you were previously.
The same outcome would also apply to your new car purchase; you might be covering the payments with your pay rise and you might have even added to your Savings & Investments, but if the amounts and the balance isn't correct then your overall savings rate will almost surely have decreased in comparison to before.
So the point of all this is to show that earning more money doesn’t automatically mean you will make more or quicker progress towards financial independence; it always comes down to how you utilise that extra money.
You need to manage your pay rise just as you would manage your budget.
Don't let my calculations and examples come across as "never improve your lifestyle" because this is not what I'm trying to tell you; I personally love my non-essential spending (beer and pizza, if you didn't already know), and I strongly believe that improving one's lifestyle is a key part of lasting financial independence.
But the increase in lifestyle spending always needs to make sense for the bigger picture, which isn't always obvious.
Figure out your balance between Essential spending, Non-essential spending and Savings & Investments to really understand what impact a pay rise might have for you. Once you know your balance you will be able to make more considered moves, instead of randomly allocating money which could actually put you further away from your goal of financial independence.
Because if that were to happen it would probably mean you just received the worst pay rise ever, and the math says you'd have been better off never getting it in the first place.