The leading cause of bankruptcy in America, you may be surprised to learn, I believe is a smaller than expected raise. This may not be entirely correct, but it employs humor to make an important point. Americans are optimistic. I feel our future has always been better than our past. And expecting this to apply to us, we often spend money, or commit to spending money today that we expect to have in the future.
Don’t worry. This isn’t another column on the subprime mortgage crisis and housing hangover. It will introduce two important concepts that, if heeded, I believe will keep you out of financial trouble.
The key to financial success is not complicated to understand, it’s just difficult to execute. One has to break the law, Parkinson’s law. In 1955, British civil servant Cyril Northcote Parkinson postulated that work expands to fill the time available for it. The monetary corollary is that expenses expand to consume all available income, and then some. The key is to break the law, drive a wedge between income and expenses and save that wedge, preferably at least 10 percent, over a long working lifetime.
It’s easier said than done. Here are two enemies.
The first is a phenomenon known as buying up. One buys up when, upon receiving news of an increase in salary, they immediately devote it to new consumption, rather than spending. A $1,200 a year salary increase, for example may immediately turn into a lawn furniture set, the payments for which are $100 a month. Since or desires are as expansive as the possibilities for consumption, and since there is always something a little nicer that we could enjoy, a propensity to buy up keeps us from saving for the future. We’ll increase the 401k with next years increase, we tell ourselves, but then next year comes and we find another enhancement our life would not be complete without.
The cost is not just the $100 a month in new consumption, but what the $100 a month could have compounded to if invested for a reasonable rate of return. At a hypothetical 6 percent rate of return, $100 a month grows to $16,388 over ten years and continues on to a hypothetical $46,204 over 20.
The second is the phenomenon is known as the invisible commitment. If buying up is out in the open, invisible commitment is its deadly cousin. Invisible commitment refers to the hidden expenses that come with a purchase. Move from a Camry to a Lexus, for example, and it’s not just the monthly payment that’s larger. Insurance may increase, maintenance may be more expensive and the premium gas certainly will be. Purchase a larger house and you certainly make some visible commitments: larger mortgage and increased taxes. There will be some less visible ones as well: higher utilities, more landscaping costs, and perhaps other expenses like the need to upgrade the Camry to the Lexus is keeping up with the Jones become important.
Neither of these concepts should is shocking, nor can or should we strive to completely avoid them. We work hard to earn well to provide an enjoyable lifestyle for ourselves and our loved ones. There is nothing wrong with enjoying a raise or, to quote George Jefferson, moving on up. Providing for our future and the financial security of ourselves and those who depend on us is also important. And if we understand the natural urges to buy up and make visible as many invisible commitments as possible, we can buy up to a secure financial future and a worry-free retirement.