A friend recently got a promotion that pushed up his salary by $500 a month. I asked him what he was going to do with that new money. He had previously been complaining about balancing his family's monthly budget even with the extra new income.
My friend replied that he'd just bought car, and the payment was around the same amount as his raise. I couldn't believe it. If you were struggling to balance your budget, why would you increase your lifestyle with a raise? My advice to him (and to you) about such a raise would be this: Pretend that you never got it.
For the past several years, each time I've received a raise, I've ignored it. I've been living off the same salary that I earned three years ago. The extra money from the raise I received in 2011, I've been putting into a savings account. My job also provides me with a cost of living increase each January, typically 1 percent to 2 percent. So in February, I raise my 401(k) retirement contributions by the same amount.
A Raise or Bonus Is Found Money
A raise is found money. It's money that you haven't included in your family's monthly budget. That makes it the perfect money to build your savings or boost your retirement investments.
"Unless you've been struggling to live on your current pay, or feel like you've been sacrificing a lot to do it, I love the idea of just pretending you didn't get a raise or bonus and instead adding it to your savings," says Scott Halliwell, a certified financial planner with USAA. "Put your raise to better use by saving it or paying off debt with it rather than just expanding your lifestyle with it."
The best thing to do after you pay off a car loan is to continue making payments like you never received the title. But instead of making payments to the bank, you make them to yourself. That's the easiest way to watch your savings grow. And the same is true of a pay raise. Route it straight into your savings account or retirement fund, and continue living off your previous salary.
Oh the Places a Raise Could Go
If you don't have an adequate emergency fund saved -- enough to cover at least three to six months of your family's living expenses -- you should make correcting that the first task for your new income.
You should also consider adding your raise to what you contribute to your Roth Individual Retirement Account or 401(k) retirement plan. If you are younger than 50 and are under the income limits, you can invest $5,500 in a Roth IRA and another $5,500 if you're married. If you're older than 60, you can contribute an extra $1,000 in a Roth IRA as a catch up contribution.
Finally, you can never go wrong paying off old debt with a new raise. Even though you will only be paying off a little more each month instead of a large lump sum, you can save a fortune in interest payments -- painlessly. And paying off a credit card that charges you 18 percent annually is equivalent to earning 18 percent on an investment.
"It's usually a lot easier to save money you've never had than it is to save money by cutting back in other areas," says Halliwell. "Raises and bonuses can make saving a lot easier."
Don't Get Caught Up In Lifestyle Creep
One of the worst things that you can do is getting caught up in lifestyle creep, where your standard of living increases with the rise of your family's income.
%VIRTUAL-article-sponsoredlinks%We often find ourselves getting carried away and spending more than we earn even after earning a new raise. Raises and promotions have the tendency to bring about new spending. My friend experienced lifestyle creep first-hand and is in trouble with a budget that still won't balance. He earned more money and tried to justify a new car payment.
Workers who's paychecks are supplemented by commissions (which may vary widely) can feel the effects of lifestyle creep more than those of paid strictly by the hour or the week. It's doubly wise to set aside a salary boost or one-time bonus when you work on commission.
"There's a psychological benefit," says Holly Perez, consumer money expert at Intuit and Mint.com. "As long as you don't spend more than your base salary, you can be confident that your lifestyle is sustainable without having to worry about cutting costs if you get a smaller-than-usual commission check. Plus, you get the satisfaction of having more money in the bank."
Should You Splurge a Little?
Of course there is more to life than simply saving and investing. Many financial experts recommend splurging, though the common suggestion is to spend no more than about 10 percent of your raise on fun. So, go on vacation. Take up a new hobby. But don't get carried away and let lifestyle creep blow your budget out of the water.
"One of the biggest mistakes people make with their finances is that they adjust their lifestyle every time they have an increase in income," says Michael H. Baker, a certified financial planner with Vertex Capital Advisors in Charlotte, North Carolina. "Bonus money is a great thing -- just don't be like Clark Griswold and spend it before you actually receive it. If you've worked hard and received a bonus, take a portion of the funds for enjoyment, and add the rest to your savings or investment accounts."
What do you do with a raise? Do you spend it all? Do you save or invest a majority of it? Is lifestyle creep really a problem or not?
Hank Coleman is the publisher of the popular personal finance blog Money Q&A, where he answers readers' tough money questions. Follow him on Twitter @MoneyQandA.
7 Bad Habits That Cost You Thousands of Dollars a Year
I'm Still Living on My 2011 Salary - and You Should, Too
Apart from the health costs (which are worth considering), smoking can drain your finances. The average cost of a pack of cigarettes is $5.51, according to the American Lung Association.
If you're a pack-a-day smoker, that means you're burning through $2,011.15 per year. That's enough to take your significant other on an one-week vacation -– including airfare, hotel and restaurants.
If that's not compelling enough, consider this: If you invested $2,011 per year ($167 a month) for 10 years, compounding yearly at a reasonable 7 percent growth rate, you'll have $27,690 within a decade. And the power of compounding only picks up the longer it has to play out. Even if you never added to that stash after the first decade, at that rate, the value will about double every 10 years.
And that's not even touching on any medical bills you may face.)
Potential cost: $2,000-plus a year (for a one pack a day in a state with near-average prices).
There's a reason that some people call the lottery a "voluntary tax" -- or, more harshly, a "tax on people who are bad at math."
Even if you're "just" buying a $1 scratch-off ticket each day, you're still throwing your money away. The odds of winning small lottery prizes are low, and the payouts are stacked heavily in favor of lottery. And the odds of winning a large lottery drawing like Mega Millions or Powerball are one in hundreds of millions. To put it in perspective, you have a (much) better chance of being struck by lightning.
And what if you're gambling with bigger stakes, such as slot machines or casino table games? Then we don't need to tell you how much you lose for every dollar you "make," because chances are, you're painfully aware of it.
Potential cost: $52 per year (one ticket a week) or $365 per year (one ticket a day). Or far more if you're hitting the casinos.
Whether you're pounding back dollar drafts during the game or indulging in high-end cocktails at a ladies' night, alcohol isn't cheap. Just a few cocktails each week can add up quickly.
Let's say you grab $1 drafts, three beers per sitting, twice a week. Factor $1 per drink as the tip, and you're paying $12 per week -– which comes to $624 per year.
What if you're drinking cocktails a couple of times a week? You could be looking at upwards of $2,000 a year in adult beverages.
Excessive drinking can also result in all sorts of other pricey problems, like fines for drunken driving, legal fees and higher insurance premiums -- not to mention that other wasteful spending moves tend to seem like great ideas when you're wasted.
Potential cost: $500 to $10,000-plus per year, depending on how much you drink, how expensive your liquor and whether or not you're bringing legal fees upon yourself.
It may not seem as "bad" as smoking or drinking, but regular drive-thru visits can add up -- both in terms of indirect health costs and and the price of the meals. Those enticing "value menu" items are rarely enough to fill you up, so you wind up buying a bunch, and the seemingly great-deal combo meals often contain more calories than the average person is would be wise to consume in several meals.
Either way, regularly eating out will take its toll. If you rely on it because it's quick and easy, consider investing in a slow cooker. Create big batches of food on the weekend that can be reheated throughout the week. Your wallet (and your waist) will thank you.
Potential cost: $300 to $2,000-plus per year, depending on how often you hit the drive-thru.
Whether you hate the dentist or you're the "suck it up and deal" type when it comes to health issues, steering clear of medical professionals can cost you big-time.
Preventive care such as annual checkups can catch potentially serious issues before they become serious. Seeking treatment as soon as you notice something feels not quite right is the most effective way to prevent little problems from ballooning into bigger ones.
Also bad? Going to see the doctor but then ignoring his advice, like dismissing his instructions to get more exercise or improve your diet.
Potential cost: Tens of thousands of dollars -– or perhaps your life.
Your car, just like your body, needs regular checkups and tuneups to run smoothly. Ignoring that "check engine" light on the dash, going too long between oil changes, or pretending that strange squealing noise will take care of itself can create excessive wear-and-tear on your car.
Will it cost you money upfront to get your car serviced, maintained and repaired? Yes. But it will cost you much more if you ignore any looming problems until you're immobile by the side of the road, waiting for the tow truck.
Potential cost: $500 to $5,000-plus, depending on the required car repair.
Any shopaholic can tell you the consequences of a retail spending spree, but even if you think you're a savvy consumer, you could be guilty of bad spending habits that quickly add up.
Do you grocery shop when hungry? Jump to buy something just because it's on sale? Open up store credit cards for that 15 percent off your first purchase, then forget to pay off the balance in time? Make impulse purchases at the register (or online)?
All of these things, while they might seem minor fiscal transgressions at the moment you're committing them, can add up. Be deliberate and strategic about your spending to get the most out of your money.
Potential cost: $500 to $5,000-plus per year, depending on how often you make impulse purchases and what types of items you're buying.