Getting a pay increase every year is nice. Getting a promotion with a significant pay bump is even better. Whether you have moved job or been rewarded with a bonus for your hard work, having more in your account each month is a great feeling
But before popping bottles of bubbly, it might be worth considering if any of this new money can be put towards future financial goals.
If not, it could just get swallowed up into household bills and the odd extra takeaway each month.
Below, Trustnet collected tips and tricks from experts in behavioural finance and financial advisers to give you the ultimate roadmap of how to make the most of a salary increase.
Premise: Avoid temptation
With extra income comes the temptation to upgrade your lifestyle. You could get a new car or finally afford that fancy health club membership.
This is called lifestyle inflation and according to Paulo Costa, senior behavioural economist at Vanguard, it is absolutely “normal and to be expected”. However, you shouldn’t give up on the opportunity to speed up your financial goals.
“If you are able to contribute a little bit more towards your savings and investments [you should]. Save as much as you reasonably can. Do your best,” he said.
By giving in to lifestyle inflation, you are only keeping yourself in a cycle of ‘pay check to pay check’ living, noted Zoe Brett, financial planner at EQ Investors.
“Instead, opt to save this extra income before you become accustomed to it. Automating savings and investments is a great way to do this,” she said.
“Think about your needs versus your wants and what sacrifices are worthwhile for a financially secure future. Do you really need to upgrade your wardrobe or would you value being able to retire to a lovely beach 10 years early whilst your still young enough to enjoy yourself?”
The real upgrade to be excited about isn’t a more luxurious lifestyle, but financial freedom, which offers no immediate gratification, so is often discounted, she noted.
“Not putting the extra cash to work for your future self if a big missed opportunity in creating financial freedom. So, ignore that celebrity spin class and opt for repaying debt or increasing wealth instead.”
Step one: Review your budget
First and foremost, update your budget. “You need to know what you are working with to ensure you put this new money to the best use,” Brett said.
There is no hard-and-fast rule that applies to everyone, but if you have specific financial goals, then all your excess cash should be working towards these.
“If you really must give yourself some shorter-term joy, then at least commit 50% of your raise to your goals.”
Step two: Allocate the money
Once you have figured out your budget, you are in a position to work out how best to allocate additional funds. This is where personal circumstances play the largest role, so below are a few options to consider.
Pay off your debt
This may be a good opportunity for you to pay off any high-interest debt, according to Ian Futcher, financial adviser at Quilter, as credit-card and short-term loans “often have high interest rates attached” to them.
If paying off your debts in full isn’t possible, making extra payments above the monthly minimum “can still make a meaningful difference, as it reduces the capital owed, shortens the repayment term and lowers the total interest paid over time”.
Consider building or increasing your emergency fund
Futcher suggested using your increased income to bolster your emergency savings, aiming to cover at least three to six months’ worth of living expenses.
“If you are already at six months’ worth of living expenses, you can look to increase this.”
Here, he diverged from Brett, for whom the decision on whether to top up an emergency fund really comes down to two things: is there a large one-off expenditure on the horizon, or have your expenses increased?
“There is no need to increase an emergency fund simply because you have more budget to do so. Any cash above short-term cash needs and three to six months' expenditure is typically put to better use for your financial future by investing the money or repaying debt,” she said.
Costa believes that $2,000 in the bank is worth more than $1m in assets, which he shared with Trustnet earlier this week.
Take out an insurance policy
Having insurance policies in place that protect your lifestyle or mortgage in case of sickness or death are “crucial”, according to Futcher.
“Perhaps before you couldn’t afford to take out this policy or could only have a policy that insured half of what you needed. This is a good opportunity to review and improve this, as this could be more valuable than your six-month emergency fund.”
Step three: Turbocharge your savings
Next would be to review your medium- and long-term savings. Once again, there is no best option, just different outcomes, which may or may not suit depending on your goals.
Save up for the short term
Maybe you want to have an accessible pot for a rainy day or are saving for a significant purchase such as your first property.
“Making sure your money keeps up with inflation is important, otherwise its spending power will be reduced, essentially keeping you in the same position as you were,” Futcher noted.
There are lots of tax-efficient ways to achieve this, such as ISAs with a £20,000 allowance or, if you qualify, a Lifetime ISA with a £4,000 allowance and 25% bonus from the government.
These can be in fixed-rate cash or in stocks and shares ISAs so offer a good variety of options.
“Be wary of putting anything into stocks and shares that you may need easy access to, as, if markets fall, you may not have the original amount you invested.”
Think longer-term by increasing your pension contributions
If after all that you still have money left over, are you and your employer making maximum contributions to your pension?
All employers must offer a workplace pension scheme. To take advantage of it, employees must contribute a minimum of 5%, with employers matching at least 3%, making a combined minimum contribution of 8%. However, in some schemes, your employer has the option to pay in more than the legal minimum, so it’s worth checking with them, Futcher explained.
“Company contributions are money you wouldn’t have got otherwise, and will be there to help provide a comfortable retirement”.
Recent PLSA data has shown that a comfortable retirement is increasingly difficult to achieve, especially for single people.
Depending on your salary, you may also want to put some into a private pension, he continued. “You can make contributions into a pension of up to £60,000 a year and receive tax relief, but you won’t be able to touch that money until you are 55 or even 57”.
Bonus tips
Keeping your expenditure the same as your income increases is a sure-fire way to increase long-term wealth, according to Brett.
“Directing extra regular income will soon build up into a financial future to be proud of,” she said. “If you put the money to use before you become accustomed to it, you’ll build wealth without ever feeling the pain of paying for it.”
Costa also talked about ‘compounding interest’ or increasing the amount you put away every year.
“If that is possible, it is a way to make your savings even more powerful and go a very long way,” he concluded.