The new paycheck trap: Why earning more doesn’t mean saving more in India

Getting a raise often seems like the beginning of financial independence. Especially for many people, the reality is that the extra money in a paycheck more often than not does not translate to more money in savings. More taxes. More EMIs to pay. And their upgraded lifestyle consumes the additional money from that raise, thereby keeping wealth stagnant.

For instance, take Neha’s example. She bumped her salary from ₹6 lakh to ₹9 lakh a year. Energised by the bump, she naturally moved to a premium rental. Bought a phone on EMI. Started spending a little more money on weekends each month. And by the end of the month, she had basically saved zero. And thus began the new paycheck trap, where in some cases, an increase in income means an increase in spending.

The anatomy of the paycheck trap

The “new paycheck trap” is where income rises, but net savings also may be flat for some time. A number of things compound this situation, and recognizing these is the first step to changing the pattern.

Increased Tax: When salaries increase, people are usually bumped to a higher tax bracket, which means there will be less of the new income added to the true take home of the raise. Exemptions and deductions aside, the net value of the raise often is less than what people expect. This can create a sense that we barely received any new money at all.

Higher Upkeep: When incomes rise, expenses sometimes also rise. New expensive apartments, upgraded electronics and new restaurants are justifications for spending more. In most situations, these small, new repeated costs add up quickly and eliminate any financial benefit from a raise. If looked at over time and excess income can disappear with lifestyle inflation.

Longer Repeats of EMI Stresses: With higher salaries comes bigger commitments to borrow money for cars, new houses or for renovations. Long term EMI’s can take a windfall of a raise, and moreover the length of an EMI tenure also increases the cost of the EMI. A significant portion of the raise evaporates, making savings planning more ordinary and potentially risking the loss of long term wealth.

Increased Social Status: Folks also have more expense with a higher salary, and also deal with more distractions. Many people now have to spend part of their raises on social distractions, gifting with gifts or experiences for weddings, festivals and other events, forgetting social obligation expenses increase. Sadly, many people’s raises go towards social commitments, rather than wealth creation.

Mental Accounting: Many people think of bonuses and salary increases as “extra” money. The notion of “extra” money encourages discretionary spending and encourages a lower portfolio contribution towards our goals of saving or investing. In the long-run, our “extra” money is really just limiting our wealth.

Four Common Ways Your Raise Disappears

EMI Inflation: The “I Deserve It” Purchase

Many professionals justify a car or home loan as a reward for working hard. But, long tenures and high-interest rates, often see car or home purchase turn into traps. EMIs can take a large chunk of your monthly earnings, leaving very little room for savings or investments.

Rent and Relocation Upgrades

It is easy to be enticed to move to a bigger apartment or somewhere much closer to work (especially after a pay raise). You might save on hire by not having to travel to work or just convenience, but then comes the higher rent and higher security deposits. The higher rent may totally offset the increase in your take-home pay. Over time and at a precise manner, this will be eating away at your net savings.

Social Signalling Costs

A bigger paycheck often comes with bigger social expectations. Weddings, festivals and your own peer pressures can push you into spending discretionary amounts that seem almost mandatory. Social signalling or social spending does not seem to have a size-able footprint but can quickly eat up a pay rise, allowing little towards wealth building activities.

Subscription and Lifestyle Creep

Having several subscriptions to OTT streaming platforms, fitness or educational apps and meal kit deliveries, or whatever else seems innocuous on its own, can add up before you know it. Lifestyle creep, where recurring and potential expenses rise with income, can easily eat away at any gains without you even noticing.

Behavioural traps and how to avoid them

Present Bias: Most people experience feelings of stress or worry around money and often prioritize that feeling by valuing immediate gratification over their ultimate financial goals. Buying the newest gadgets or treating themselves to luxurious getaways can feed a quickly-diminished feeling of relief, since they just decreased the amount they saved or invested.

Anchoring: People also anchor spending to their new salary, literally allowing their new salary amount to dictate their spending behaviour, and then quickly changing their lifestyle to meet it. Easily, this makes even a significant raise feel like the same standard of living and just leaves the person in the same situation with no newfound wealth.

Mental Accounting: Many people will treat their bonuses or incentives, or even raises, as “extra money”, rightfully believing they earned it but do not direct it to investments. This psychological habit lessens the portion of one’s income set aside for long-term growth, and stops any future savings.

Hedonic Treadmill: People adapt their lifestyles as their incomes go up, so when they upgrade their lifestyle, they soon adjust their definition of what a normal lifestyle looks like and displace all previous improvements. In summary, one only continues their wealth accumulation if part of every raise is explicitly directed for investment.

A Step-by-Step guide to securing your raise

#1. Follow the Rule for a Raise

Once you get a raise, before you spend any of it, decide where it will go. The easiest thing to remember is, if you got a 20% raise: invest 50% of it, improve your lifestyle by 30% of it, and take 20% to pay down debt and have something left over for your financial goals to pay down debt. We want to make sure you convert your raise to your own wealth, not just short term spending.

#2. Save your Money Automatically

Set up an automatic transfer when your salary hits the bank account to your SIPs or your VPF or NPS. This prevents the impulsive reaction of spending your raise and it ensures that you are saving every month without having to lift a finger. You end up building in disciplined wealth for the long term, which is a much lower barrier to entry than having to be disciplined every single month.

#3. Grow your SIPs

Now every time you get a raise, increase your SIP by 10-15%. This will help you stay ahead of lifestyle inflation and continue to build your long term investment. Small incremental increases add up over time via compounding and you do the heavy lifting in the beginning to set your rate of life.

#4. Control Lifestyle Creep

You see every raise does not mean you are able to upgrade your lifestyle. You can purchase major items such as apartments, cars, or gadgets basically on a budget that is structured. At the end of the day, controlling your discretionary spending will ensure that just because your income is growing, it can be changed into wealth.

#5. Manage your Debt

Keep your EMIs within a manageable chunk of your EMI and know the interest rate on loans. If you have the ability, prepay your loans. Ensure you have an emergency fund of 6-12 months. Good debt management effectively doubles your amount available for savings and investing toward your long term life goals.