Purchasing power refers to the amount of goods and services you can afford to buy with your income, taking into account prices and the cost of living.
If making financial decisions in life were a video game, then you might have ‘real-time’ access to your purchasing power every time you faced a spending choice. For example, can I afford to buy this new car, and how should I pay for it? How will my decisions impact my ability to make other purchases, like affording a house?
The reality is that you don’t need access to a real-time indicator, but understanding your purchasing power can help you make informed decisions that put you in the driver’s seat without compromising your financial well-being.
Purchasing power is a vital personal finance metric because it provides a realistic view of the value of your money over time, especially in the face of inflation. By understanding and monitoring your purchasing power, you can make more informed decisions about budgeting, saving, investing, and long-term financial planning to protect and grow your real wealth.
If you are interested in learning more about purchasing power and how to calculate it, then please read on.
Calculating your purchasing power
You can calculate your purchasing power in a few different ways, depending on what you want to measure. However, the most effective method for calculating your individual or household purchasing power is by measuring the change over time in your disposable income minus necessary expenditures.
To accurately calculate your purchasing power, you will need income and expenditure data for the time periods that you’re interested in assessing. If this data is not readily available, you will need to compile from different sources, such as your tax returns, bank and credit card statements.
To help you measure your purchasing power, I created a worksheet to guide your calculations. A completed worksheet example is included below.
In reviewing this worksheet, there are a few insights worth highlighting:
- Despite their cost of living having increased faster (6.3%) than disposable income (5.0%) in 2024, purchasing power increased year-over-year, boosted by cash-back credit card rewards (up 16.8%).
- The debt-to-income (DTI) ratio is close to the 36% cutoff used by lenders to assess financial health and home affordability. DTI is an important indicator of their readiness to buy a house.
Tracking your changes over multiple time periods allows you to pinpoint potential issues, evaluate trends, and forecast your future more accurately.
Predicting changes in inflation rates is difficult, but using past data as a baseline is an important starting point for financial planning. Understanding changes in your cost of living over time is crucial for retirement planning, as noted in my new book.
A recent report warns that if life expectancy increases significantly, retirees could face 50-year retirements. It claims that, at just 2% inflation, even a conservative portfolio generating 4-5% net returns could run out of money 10 to 20 years too soon.
Getting started
By understanding how to calculate and interpret purchasing power, you can gain a clearer picture of your financial health and make more informed decisions to achieve your financial goals in the face of changing prices. This knowledge can inform your decisions by allowing you to:
- adjust your current spending habits to maintain your desired lifestyle in the face of rising costs, and
- estimate the future cost of your goals more accurately and plan your savings and investments accordingly to maintain or enhance your desired standard of living.
If you are interested in measuring your purchasing power, I created this infographic to help you get started.
It Pays to Know!