I live (and want to live) a comfortable life but I do not want to maximize my consumption just because I have money to do it.
In 2014, I was in the looking for a house to buy (primary residence). Like most rational people, I wanted to start with a budget. I wanted to find out answer to the following question:
“Given my income, what is the least amount I should spend on housing?” I searched for days and weeks, but did not find an answer.
Let me first elaborate on my question. I have good income. I tend to be frugal (simple living). But I did not want to be frugal to the extreme, I did not want to end up below the ‘suggested bottom’. I had often heard people talk about “You should not spend more than x% of your salary on housing”. I wanted to hear something like “You should spend at least y% of your salary on housing”.
I did not find my answer, here is what I found – I found hundreds and hundreds of websites and blogs telling me ‘the upper limit of how much should I spend’. Here are some examples:
1. Your monthly total debt should not be more than 43% of your take home pay
2. Your house should not cost more than 2.5 times your gross annual base pay
This related to my car buying experience too – the salesman always kept on coming back to monthly payments saying “It is only $391 a month, you can afford that”. And I was thinking in my mind “Should I afford it just because I can?”.
Coming back to my housing question – I do not have an answer today on how much is the minimum you should spend. Frankly, I did not start to write the post looking for an answer.
All I would like to discuss today is – should you afford what you can? Since no website was able to tell me the ‘suggested minimum’, I believe most people are not thinking along those lines.
Per the affordability calculator present on www.zillow.com, someone earning $100,000 a year without any other debt can afford a house worth $489,216. They make the calculations using some assumptions and those assumptions are not our focus today.
The focus today is – should someone earning $100,000 a year go and buy a house that is $489,216. Well sure BUT keep in mind the trade off. Spending versus saving is always a trade off. When you spend, you fulfill a need or experience (or acquire) something desirable. While when you save, the following happen:
- Saving makes you stress free (relatively)
I sleep better because I have money saved up for a rainy day. I know that I can survive several months if I lose a job. I know I do not need to borrow if there is a health issue not covered my insurance. I know I can get my car fixed immediately should it run into problems. So on and so forth, having money saved up let’s me sleep peacefully and not worry about unplanned expenses coming up.
- Saving gives you flexibility
You can convert cash into anything easily. For example – You can convert cash into stocks or bonds or a car. Once you have a bigger house, you have a bigger house. You will have to sell the entire house, you cannot just reduce one bedroom.
- Saving will make you retire sooner
Although I do not think I will ever retire, I will continue to work in some shape of form. Sitting idle/ relaxing/ fishing is just not in my DNA. But even for people like me, the fact that they can quit their job if they want to is very soothing. When I am having a bad day at work, I look at my boss and think what worse can happen? He will fire me, so what? I will relax for a few days before finding another job. I do not work for the money.
Coming back to our example, where the house costs $489,216. Monthly mortgage payments are going to be $3,000 (under some assumptions about the interest rate). I recommend that you not only think whether you can afford $3,000 a month; you should also think whether you should afford $3,000 a month.
Is there a compelling reason for you to buy that big a house? Can you just compromise just a little? Is the extra bedroom really necessary? Do you really need enclosed parking? Can you live without a swimming pool? Can you keep your bench press in the garage? Can the kids stay in one room when you have overnight guests (rather than having an extra bedroom for the guests that is used 10 days in a year)?
If you let go of any of these, and your mortgage payments come down to $2,500 from the original $3,000. Do you know how much difference can that $500 make? If you invest the $500 every month for the duration of the mortgage (30 years) and assuming it earns 8% returns, you will have about $745,000. Remember, compounding is your biggest friend.
Law of marginal utility (a.k.a. Law of diminishing returns)
Wikipedia defines law of marginal utility as “The first unit of consumption of a good or service yields more utility than the second and subsequent units, with a continuing reduction for greater amounts.”
Let me simplify this for our discussion – for a person who is hungry, the first slice of pizza is precious. The second slice of pizza is still precious but not as much. The third slice of pizza probably has very little value. This is law of diminishing returns.
I would guess the same is true for a house. Buying a 2 bedroom house provides a lot of value as compared to a house with one bedroom BUT buying a house with 5 bedrooms might not provide as much additional value over a 4 bedroom house.
A rich person is not the one who has the most, but one who needs the least…
Finally, remember – saving is only one of the 4 pillars of getting rich. Do not forget the others.