Financial well-being: what we can learn from less well-off households

How can you assess your financial well-being? In another article on the state of mind of those who achieve financial success, we highlighted the importance of updating your ideas in accordance with certain principles in order to maintain a healthy relationship with your finances. As well as objective figures that allow us to assess the state of our finances, our perception of the situation is just as important when it comes to making the most of it and improving it.

Being comfortably off in financial terms is not just measured by an objective assessment of our assets, but also by our perception of the situation. For this reason, if we fall on hard times financially, it is key that we do not focus on what we are missing or we risk getting stuck in a vicious mental circle. When talking about financial perceptions, it is paramount that we know how to distinguish between scarcity and frugality. It is possible to have very little but to manage your finances well and to feel satisfied. The opposite is also true – you can have a lot and still feel that you are wanting.

What is financial well-being?

For a long time, we tended to assess the financial health of consumers via the objective and quantified state of their finances and their access to financial services. And of course, this plays a role. A general definition of a person’s primary financial well-being must include the concept of the ability to survive, i.e. having the financial means available to comfortably meet basic needs – food, housing, healthcare, resources etc. This ability to survive requires having sufficient recurring income and/or savings to avoid having to borrow to meet daily expenses related to these basic needs.

Behavioural finance has now established that financial well-being is more complex and includes psychological, behavioural and perceptual concepts which have an equally important impact on the objective state of health of a person’s finances.

It is now established that financial well-being includes psychological, behavioural and perceptual concepts which have an important impact on the objective state of health of a person’s finances.

In 2017, the scientist Brüggen and her co-authors defined financial well-being as, “the perception of being able to sustain current and anticipated desired living standards and financial freedom”. Seen from this new angle, we can understand why a person who lives frugally – but in an environment where they do not feel the need to consume more – can feel truly free and a sense of financial well-being. In contrast, this also explains why someone living in an environment where they are constantly comparing themselves to those with a higher standard of living do not experience financial well-being. They will feel constantly under pressure to consume more and even to live in excess of their rather comfortable means. Obsessed with always wanting more, such people will be in a state of financial distress. This is not a sustainable way to live and may endanger a person’s mental and financial health.

This phenomenon is known as the Easterlin paradox. Identified for the first time in 1974 by Richard Easterlin, it describes the phenomenon whereby above a certain threshold of income, the marginal increase in well-being derived from a rise in income tends to lessen or even decline. This means that it is the state of mind of a person – and not their income – which is having a negative impact on their financial well-being.

The criteria for financial well-being

In a scientific article in 2022, F.L. Carton and his colleagues tried to define new criteria to assess financial well-being for all people, but with a specific focus on less well-off households in Ireland. Their research identified three major criteria for assessing financial well-being both in objective terms and in terms of subjective perceptions – meeting financial commitments, considering yourself financially comfortable and adopting a resilient attitude for the future.

Meeting your financial commitments. This consists of measuring whether individuals are in a position to meet their current and future financial needs whilst avoiding falling into recurrent payment problems and accumulating payment arrears. Among the less well-off households studied, the scientists found a high level of financial well-being among people who were able to be flexible, readjust their expenditure and manage to avoid falling into debt. This is an important lesson, as it is possible to have a comfortable level of income and still sink into debt. An unforeseen change in circumstances, however temporary, can result in a sharp drop in income and prevent us from meeting the payment deadlines on our outstanding loans.

Being financially comfortable. This criteria allows an assessment of the extent to which a person perceives themselves to be in a situation that they themselves qualify as financially comfortable. This measure is not correlated to income levels but takes a range of criteria into account, such as being able to repay loans on time or, more generally, being in the black, however modestly.

Being resilient for the future. This criteria is used to establish the extent to which a person is capable of recovering from an unexpected event or a financial shock, or has access to regular savings for family projects. Impulse buying or being unaware of being in a spending spiral has a negative impact on this category.

Lessons drawn from less well-off households

Based on these new criteria for assessing financial well-being, it’s time to include in your financial routine some of the best practices inspired by people who, although they live modestly, consider themselves to enjoy a satisfactory level of financial well-being.

Take back control. You can start to change your habits by asking yourself this simple question: does your money (the supposed lack of it, the need for more) control your life or does your lifestyle allow you to control your incomings and outgoings? This is a major consideration that will allow you to reassess a certain number of good and bad habits. The key is to answer honestly.

Say no to social pressure and learn to respond to your real desires and needs.

Stop making comparisons. Did you know that many people who are very comfortably off are overindebted because they can’t help comparing themselves to and envying those who have even more than them! Someone with a modest income level but a feeling of financial well-being has understood that comparisons to others only cause frustration and a feeling of want, which is not necessarily related to their own desires. Say no to social pressure and learn to respond to your real desires and needs.

Appreciate rarity and choose quality. Have you heard of the paradox of plenty? It occurs when a rare resource that is difficult to obtain becomes widespread and plentiful. It is no longer appreciated and we grow tired of it. If you are never satisfied and have the impression that you can have everything in massive amounts, something is amiss with your financial well-being. A person with a modest income level knows how to appreciate rarity and to establish financial plans that will help them achieve the things they really want. The level of satisfaction is all the greater once the goal is achieved. Ask yourself what truly motivates you, draw up a plan and look for quality. Stop accumulating possessions for the sake of it. Wanting more so that you can realise a precise project or respond to a real need is one thing, wanting more for the sake of it may help grow your capital but it will not increase your financial well-being

Get the most out of what you already have. The current environmental situation encourages all of us to make an effort to waste less. This approach will also benefit your financial well-being. Instead of buying more and more things, shouldn’t we learn to value and to appreciate what we have more? The least well off often have no choice but to regularly resort to this practice, but some manage to make this a virtuous behaviour that is a source of satisfaction. We can all take inspiration from this and try to do the same. Apply the R rule to the goods in your possession – reuse, repair, recycle, reduce, repurpose.

The R rule – reuse, repair, recycle, reduce, repurpose

Distinguish between good and bad debts. Having debts isn’t necessarily a bad thing, but you must know how to distinguish between good and bad debts. In simple terms, a bad debt is taken out to pay for something which is not essential and whose value will deteriorate resulting in a loss of wealth. For example, this is the case with personal loans taken out to pay for a second car that is purchased for pleasure and not out of necessity. A good debt is taken out for something that can be used in the immediate term and that will create a return and additional wealth in the long term. This applies to the purchase of a property – unlike when your rent, you become the owner when the mortgage is repaid.

At the start of 2022, the Central Bank of Luxembourg published figures for household indebtedness. These showed that in Luxembourg, the ratio of debt to disposable income has more than doubled in 25 years, from 75% in 1995 to 175% in 2020. Looking at the details, household indebtedness was mainly influenced by mortgage debt, which grew from 47% of disposable income in 1999 to 141% in 2020. What is interesting is that the other components of household indebtedness – specifically including consumer loans – remained stable at 35%.

So although households in Luxembourg are more indebted, the central bank emphasises that they hold the financial assets that may help repay the debt in the event of a negative shock to disposable income. The financial assets of households have actually risen faster than disposable income. However, we should remember that with the same level of indebtedness, a household with a higher level of income is less exposed to a financial shock than a more modest household. This highlights the importance, particularly for more modest households, of systematically assessing and, where necessary, cutting or readjusting their debt levels or selling assets in order to ensure a sustainable level of financial well-being.

Remember that the key to financial well-being lies in financial freedom. A mortgage must represent an appropriate investment for the future and not crush your daily freedom to enjoy your money! Achieving total financial freedom is possible, but it is a long road and requires a good deal of discipline. Today is the best day to get started.