Though it seems to run completely against logic, high income can lead to high debt. While it’s generally thought that high income is the solution for high debt, the outcome is often the exact opposite. Often is because there is a certain amount of privilege that a higher income produces, and that can lead to bad habits and unrealistic expectations.
Here are some of the main reasons why I income can lead to high debt.
This is a theme that has been discussed throughout the personal finance blogosphere, and for good reason. What it means is that lifestyle tends to increase with income level. That is, wants and perceived needs rise to fill the available income.
It works something like this. You’re living happily in a $200,000 house, and you get a promotion complete with a 25% pay increase. All of a sudden, the humble home you have been living in comfortably for the past several years is no longer adequate.
How does that happen? In reality, there’s nothing wrong with your current home. But the higher income level raises the bar in your life. Because you can afford a more expensive house, you begin to fabricate reasons why it’s absolutely necessary.
For example, you might begin to fixate on being in a better school district, having a higher ultimate resale value, more space for more stuff, and a higher tax write off that will minimize the higher house payments.
None of these perceived advantages will guarantee a more favorable outcome in your life. But when we’re searching for a justification to trade up, just about any excuse will do.
Throwing caution to the wind, and allowing emotion to rule the day, you purchase a bigger house, complete with its higher mortgage payment, property taxes, insurance premium, utilities, and repair and maintenance costs. And then there are the more expensive toys needed to fill it.
That’s lifestyle inflation.
“Keeping Up With the Joneses”
We’re not going too spend much time on this one, since we all know what it’s about. But be aware that high income feeds this beast. It provides you with more opportunities to immerse yourself in the competition with your peers. And as is the case with competitions of all sorts, once you’re in it, you’re likely to keep feeding it even when the cost overwhelms your high income.
Forgetting the Fundamentals
When you live on a more limited income you’re forced to make trade-offs. Those trade-offs not only enable you to survive comfortably, but they also create strong financial fundamentals.
For example, you might avoid debt for fear that your income won’t be sufficient to cover it. You might also save money regularly, out of concern for a job loss. And on a purchase-by-purchase basis, you may pay careful attention to the price/quality balance of any product or service that you buy.
Ironically, high income can undo those fundamentals. Because you enjoy a more generous income, you may be less concerned with going into debt, saving money, or buying intelligently.
This shift can come about because high income often causes a greater concern for convenience. As a high income earner becomes more concerned with freeing up time, he might spend more money paying for conveniences that enable this to happen.
For example, where once he cut his own lawn and cleaned his own house, he now pays outside services to do both for him. Home cooked meals are replaced by increased visits to restaurants, while the simple pleasures of home and low cost hobbies are replaced by costly entertainment. And on it goes.
The thinking behind this may be sound on one level, but it all leads to a higher cost lifestyle, and that opens the door to debt.
Though we generally think of optimism as a positive, it can actually be a negative when it comes to finances.
If you are in a high income situation, and particularly if you’ve been on the income fast track during your career, you might actually suffer from excessive optimism. That could manifest itself in the form of a belief that you will always make more income in the future, and even that your investing activities may be more successful than reality will permit.
If you base your spending habits on that kind of optimism, sooner or later you will crash into the Wall of Reality. That wall has a way of disrupting the plans of all of humanity, regardless of income level.
For example, you may be so optimistic about your future prospects that you take on more debt than you can reasonably afford. You assume that your future higher income will cover it.
At the extreme, excessive optimism could lead you to the mistaken belief that you are bulletproof in your career. You might reason that your high income makes you irreplaceable – after all, why else would they be paying you so much money?
The reality however is that no one is irreplaceable. It’s even possible that the loss of your current job could result in a lower paying position in the future. If your cost of living and debt level are based on your current income, the lower income could result in a serious debt problem.
How to Avoid the High Debt that High Income Can Produce
It’s easier than most of us think to become intoxicated by a high income. And for that reason, it’s important to avoid the bad habits and expectations that could put you into a high debt situation. But try these instead:
Get comfortable living one or two levels beneath your means. The idea is to never completely fill out your paycheck with living expenses. Not only will this guard against lifestyle inflation, but it will also provide you with extra margin in your budget for savings and investments. Speaking of which…
Increase your budget for savings and investments. These are the first budget categories that should increase as your income does. Savings and investments are the part of your income that you keep for the future. The part that you spend will be gone forever. If you increase your savings and investments at a level consistent with your income growth, you’ll not only avoid financial disaster, but you’ll move rapidly toward complete financial prosperity (high income, high assets, low/no debt).
Debt is not your friend, regardless of your income level. If anything, debt should decrease as your income rises. A more generous income should result in less need for debt. This should obviously include consumer loans, such as credit cards and car loans. But it should also include so-called “good debt”, like mortgages and student loans. All debt is bad debt once you’re making the payments!
Realize that money is about freedom. The ultimate purpose of money should be attaining financial freedom. That includes the recognition that all income sources are ultimately temporary. You should be preparing for the day when your income will no longer be there, either because of a decision by your employer, circumstances in your industry or profession, or by your own choice to go in a different direction.
When you are a high income earner, you have two choices: either 1) spend your money living well in the present, even if that means incurring debt, or 2) preparing for the day when a high income may not be central to your life. One way generally leads to debt, while the other generally leads to prosperity.