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.
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.