Consumption Smoothing

by Adam on March 5, 2010

retirement nest eggThe over-riding reason why I started Magical Penny was to evangelise the power of compounding returns. In more simple terms it was to tell people that if they save a little now, then over time they have a chance to end up with a lot. And the increase that can occur over time when a good annual rate of return is achieved is more than you would imagine.

The idea of saving today to leave you with a lump sum for your ‘golden years’ certainly isn’t original. It’s fundamental message of traditional retirement planning strategies.


Don’t worry. There’s another strategy to make sure you live a full life without having to save so much in your 20s and 30s and still have enough when you stop working. You’re probably already doing it to some extent to allow you to get the things you want and need today when you can’t afford them. What is this wonder strategy? It’s called consumption smoothing.

Saving Rules OK

Regular readers will know I’m a big fan of saving money to buy things with cash. Not only is it less risky but I don’t think people give much thought to the financial cost of how much buying things on credit can be.

When it comes to buying bigger things like a house, however, not even I am willing to wait until I can pay cash for it! Sometimes debt is worth the price because, as Sean reminds us, the opportunity cost of waiting can be too high.

A place to call home

In the case of mortgage debt, it’s often a win-win for both the borrower and the lender. The borrower gets to enjoy their own house, as it provides a form of stability in their life and gives the owner the comfort of being able to paint the walls any colour they want. The lender is also happy because they can be confident that they won’t lose their money because the house is ‘secured’ against the debt –if you can’t pay the mortgage, the lender gets the house.  It is therefore a lower risk for the lender- the reason that mortgage debt interest rates, the cost of borrowing, are so low compared with other debts. There are also many Join the Facebook group that make buying a house easy.

Consumption smoothing the practical way

Taking out a mortgage is a simple example of consumption smoothing in practice because rather than making one huge payment to buy a house at the start, you can pay for it gradually over time. Not only are your payments smooth, but your lifestyle level is smoothed too as you get to enjoy living in your house for the whole time of your mortgage. I’m sure you’ll agree that this is much better than living on the streets for 20 years as you save up to buy a house before moving into a mansion once you’re reached middle age.

‘Consuming’ Education

Other forms of debt allow you to take advantage of  consumption smoothing too. Student loans for example, allow you to attend university at a time in your life when you most likely don’t have any money at all. You get to ‘consume’ a university education without paying for it until after graduation. Students do this (or should do this) because they have the expectation that the degree will help them pay back the loan and achieve a higher income (although as Andy reminds us it is not always true). Like in the mortgage example, consumption smoothing through debt has the potential to be a great strategy for students because of the opportunity cost of missing out on years of graduate earning potential if they were forced to save to pay for tuition out-right.

So consumption smoothing is testament to how the use of debt can be helpful. However, should consumption smoothing be taken to the next level?

Living the Perfect Consumption Smoothing Lifestyle

ProfitIf you’re ambitious, student loans are just the start.  Why not really take advantage of consumption smoothing? On the assumption that you’re going to be earning much more in the future than you do now, you could take out all manner of loans: perhaps car loans, home improvement loans or even just maxing out your credit cards. By doing so you can raise your consumption, and therefore your lifestyle, above your current earning level.

Next, the plan would be to increase your income until you reach a point when your income and expenses are equal. At this point, if you are following the consumption smoothing strategy correctly, you would continue to attempt to increase your income but any raises achieved should be channelled into paying off your debts. Over time your debts are gradually paid off as, despite an increasing income, your lifestyle and consumption levels have been kept at the same level. By the end of your career you are earning much more than your ‘smoothed out spending plan’ allowing you to accumulate funds for your retirement. The extra funds saved then help you maintain your lifestyle when you income drops at retirement.

Sounds too good to be true?

In principle this plan is brilliant as it allows you to consume more when you’re young when you’re not making much, safe in the knowledge that your future self can easily afford to foot the bill.  Why live like a pauper then a king when you can simply live comfortably all your life?

Are you up for it? Try this simple test

I encourage you to try out extreme consumption smoothing if you can pass the following test. Walk through the steps outlined below and if you get to the top of the 3 steps then you have my blessing to live the consumption smoothing dream!

Step 1

Are you disciplined with your spending? Some people might find it hard to spend lots of money when they are young. After all, there are not many things to buy are there? 😉 Could you manage it? If you think you could struggle through spending lots of money when you’re young, move on to the next step.

Step 2

Congratulations, you’re one of the rare people that like spending money! Let’s try to get you to the next step. It’s quite easy. All you have to do is promise me that you’re sure that you’ll never lose your job and you will never be without an ever-increasing income. I’m only asking because one day you’ll need pay back the expensive debt that you would have got yourself in in step one, buying those new cars perhaps, or going on those expensive holidays. If you are sure that you’re a value-creating machine and nothing will go wrong in your life, then go ahead, move up to step 3.  You deserve it.

Step 3

Wow, you’re awesome! With an indestructible career that’s always on the up and up you deserve great things. Now you have to promise me that you’ll continue working hard to increase your income even more, but that you will also keep your spending at the same level that you’ve had since you started this journey. Doesn’t sound so good? Well, get used to it because you’ve come this far and you can’t go back. Keep working hard and pay off that debt otherwise it will keep growing with interest and fees. And when you’re done cleaning up that mess, you have retirement to save for too!

Life is all about balance and unbalance!What do you think of consumption spending now?

Although it can be really helpful for student loans and houses (traditionally known as ‘good debt’)  it soon becomes hard-work when other expenses come into play. Like many things, it’s a question of balance or rather in this case, unbalance. By saving a lot more in your 20s (and if everything goes well) you can always be increasing your consumption and lifestyle.

The only way is up!

Also, you would be in a much better position if and when thing in your life don’t go to plan too.

Making the commitment to build solid finances today might not seem as fun as the ‘consumption smoothers’ at first but I think it’s worth being a little less comfortable in your 20s. If not now, then when?. Over time you’ll catch up with those ‘consumption smoothers’, and your ascent to wealth will be made easier still through the power of compounding returns.  How about you?

We are nearing the conclusion of Magical Penny’s foundational series on Debt. You can find other articles in the series here.

There’s been some exciting things happening behind the scenes here at Magical Penny. Twitter feed and read the Twitter feed to get in on all the action. Also don’t forget to sign up for the newsletter which is launching shortly. If you have already subscribed to the email post updates you don’t have to worry as you’ll automatically receive the newsletter when it launches.

Have a great weekend everyone.

{ 4 comments… read them below or add one }

Rightly Knightly

I see what you’re trying to do.

Its much more common for young 20 year olds to think that the wage they are on is only the ‘begining’ so they spend up to that wage expecting an massive increase later.

Which doesn’t always happen.

This leads onto what i’ve always consider I could write about – attitude to jobs, and finding the right career. Many people have the expectant attitude you describe but not many have the knowledge and experience to truly get that higher wage.

But although you are putting down consumption smoothing there are parallels.

You are trusting your future not to hold so many financial bumps and bruises. If it did your savings could dwindle and disappear.

Others are trusting themselves, their skill, their ability and their knowledge of the jobs market. If you truly have the skill, the ambition and aptitude you can make it down this path. You’d need as much singlemindedness as one would need to follow your saving attitudes.

I think the choice of whether you save or look for higher income (which is really the crux of your blog) is often out of the individuals hands. Your personal situation allows you to save very well, but what if people wanted families or to start living life now?

You would say delay your life for a better future. But as one example, with regard to families, the longer you delay the more chance there is of problems etc. Time doesn’t always look kindly to delaying. And time is one thing no hoard of pennies can buy you.

My personal opinion? A middle ground between your savings attitudes and looking outward toward work. An individual should not let themselves down on either front.


I too can see the very valid point you’re making here. My flatmate is very fond of saying that in these modern times, everybody wants ‘the moon on a stick’ – i.e. everybody wants nice, aspirational things now and is willing to take out ridiculous amounts of credit to get there with little thought to the aftermath, and I’d be surprised if we couldn’t all admit to having taken this attitude at one point or another.

The factors which have to be taken into account when considering a ‘consumption smoothing’ use of credit are myriad, but there are a few important ones. Firstly, how guaranteed is any future income? Of course nobody can predict a redundancy or sudden unexpected large expense, but if you’re in a steady job you should be able to predict this with some certainty, and as always, having a ‘rainy day fund’ (I’ve read somewhere that you should aim to have at least 3 months’ salary aside in this) is prudent. Also, I don’t think anybody should ever take out more credit than they have the ability to meet the repayments on, surely a no-brainer?

Secondly, you should do a rough cost/benefit analysis on the thing you are buying. Is the opportunity cost of not having this item immediately outweighed by the real cost of the credit?

Finally, and for me, most importantly (and often most overlooked) is the cost of the debt. APR here is king! I stand open-jawed in disbelief at the adverts on daytime t.v. for short term bridging loans with APRs into the thousands of percent. How could anybody be idiotic enough not to see the danger here? The ‘best’ type of credit is that where, compared to the cost of ‘real’ money, you are in fact making cash over what you would be doing if you just stuffed the money under the mattress each month. The best example of these is a 0% deal, but realistically any debt with an APR under the current rate of inflation (latest January retail price index is 3.5%) is debt where, provided you can be assured of making the repayments, you are coming out a winner on both fronts – you get the consumption smoothing and you are coming out better off in real monetary terms as well. It pleases me immensely that all my myriad debts (training loans, student loan, car loan, credit card debt) have APRs below the [current] rate of inflation, and in fact all but my training loans are [currently] 0% loans (essentially ‘free’ money).

As a final point, you mention “that mortgage debt interest rates, the cost of borrowing, are so low compared with other debts”. Not necessarily the case at the moment – the unwillingness of banks to lend post credit-crunch means that historically, compared with Bank of England base rates, the cost of mortgages, especially for first time buyers, is pretty high!


Great points both. I do however have a few rebuttals.

“You are trusting your future not to hold so many financial bumps and bruises. If it did your savings could dwindle and disappear.” -Saving aggressively and being single-minded with career and income building are not mutually exclusive as you make it sound like.

“You would say delay your life for a better future.”
Yes i would.
However you make a great point about starting families. No one is rightly placed to say when the best time to start a family is. This is an example of when personal finances should be built around your life, rather than building your life around your finances.
For those of us without children, I don’t think we really appreciate how good we’ve got it with only ourselves to spend our hard-earned money on. I hope people take this message to heart.

@Sean. Once again, thanks for the quality comment. You actually helped inspire the direction of Monday’s post, where you’ll be able to read my response in a little more detail.

As for your mortgage comments, I’ve not had a chance to read all of those links but I will. I would however say that although the base rate is low and therefore makes mortgages seem expensive, I believe this is a very short-term view. Mortgage rates are not going to get any lower so the absolute best thing to do would be to fix the rate for as long as possible. It might seem the more expensive thing now but it will zap away the risk of a ARM adjusting unfavourably in the future, whilst giving you a better rate compared with a Bank of England base rate that inevitably will rise. The only way my plan would fail would be if the base rate stayed low for an extended period of time, but personally I think it’s too risky NOT to fix a mortgage for as long as possible.

Admittedly I have no experience of mortgages so this is just speculation: easy for me to say as I’m currently detached from the housing and mortgage market.

Rightly Knightly

Right back @tcha Adam

You immediately reduce the audience of your blog if you don’t consider that many people have already started living their lives.

I’ve started my family, Sean has started spending more. Perhaps you need to put thought into changing peoples current attitudes, ways to reduce spending without the pain and giving the reasons for it as opposed to your current ‘this is how your attitude should start stance’.

Most people have already started, and as I stated before, no amount of pennies can buy you time so the desire the delay indefinately is a difficult message to put across.

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