I’ve been a personal finance nerd for a long time and one question has always stumped me: how much should I be spending on housing?
Housing is the biggest expense for most people, so its important to get it right. Obviously the less you pay for your housing the better, but what should you shoot for?
Most people seem to think that your monthly housing payment should be capped at a certain percent of your income. But this seems a little arbitrary. If I tell you that you shouldn’t be spending more than 30% of your monthly pay on housing, how do I justify that? Why didn’t I pick 35% or 25%?
Finally, I think I have an answer.
The Case for Keeping Your Housing Costs Below 30% of Your Income
What finally let me settle on 30% was a study of the consumer expenditure survey done by the bureau of labor statistics.
I initially relied on this data for the post on Big Wins and the 80/20 rule. That post argued that you get the best bang for your frugality buck by focusing on the “big three” expenses that people spend the most money on.
Here are the big three categories along with their percent of the average consumer’s total spending in 2019:
This data along with the breakdown by income level led me to the following two arguments for capping your housing at 30% of your after tax income:
“Average” People Are Broke
The reason why you’re here reading a personal finance blog is to improve your financial situation. You don’t want to be average, you want to beat the average.
If the average person has housing costs that represent 29% of their after tax income (and 32.8% of their spending), you should make a deliberate effort to come in underneath that number. The lower you can get your expenses, the better.
The popular personal finance personality Dave Ramsey has a famous saying:
“If you will live like no one else, later you can live like no one else.”Dave Ramsey
In other words, if you want to build the wealth that few people build, you need to make the sacrifices that few people make.
You should want a higher income than the average person. You should want to save a higher percent of that income than the average person. In order to do that, you need to spend a lower percent than the average person. And the most important category to save money in is housing because it’s the biggest.
At Higher Income Levels, People Spend a Lower Percent on Housing
Here were the numbers that really got my attention. Take some time to carefully consider this chart:
|Income Range||Mean Income||Mean Housing Cost||% of Income|
There are a few things to note here.
Fist of all, it’s wild that not only are people in the lowest income bracket spending more than earn in general, they’re actually spending more than they ear on housing alone. There must be lots of government assistance keeping them afloat. That, or their debt is spiraling out of control.
But the most interesting thing is that although the absolute spending on housing increases in every income bracket, spending as a percent of income actually decreases. This holds true for every single income bracket.
As income goes up, housing spending as a percent of income goes down.
You’ll notice that those making more than $70,000 a year—a salary most people would consider enough to live comfortably—are the first ones to spend less than 30% on average on housing.
Of course, there are a few different explanations we could offer for this phenomenon.
Financial Savvy and Income Increase Together
The same intelligence that helps people earn a high income helps them realize the importance of being frugal in their housing.
Of course, we know this is not always true. As The Millionaire Next Door demonstrates, many high income earners are clueless when it comes to building wealth.
Also, many people who are very sharp (both in general and when it comes to money) don’t have a high income. This can happen for a few reasons, but one of them is their age. People’s income tends to increase as they get older, which leads us to the next explanation.
Related Post: Book Review: The Millionaire Next Door
Income Grows Over Time
In general, most people make more money as they age. Their income usually changes every year, but they don’t move every year. If you’ve been living in the same house for the last 7 years, chances are that your income has grown but your housing costs haven’t.
This might help explain the chart. A person making $83k a year and spending 26% of it on housing might have bought their house when they were making $72k a year and the same housing payment represented 30% of their income.
This leads us to a potentially dangerous strategy: What if we ignore how much we’re spending on housing as a percent of income and trust it will go down over time?
This strikes me as an irresponsible move. It might pay off, but it probably won’t. You’re better served sticking to an informed constraint and enjoy the blessing of falling housing costs as a percentage of income if your income indeed rises.
Spending Less Than You Earn
The single key to building wealth is to spend less than you earn and invest the difference. Let’s take another look at the consumer expenditure survey, this time looking at total spending vs. income instead of housing spending:
|Income Range||Mean Income||Mean Spending||% of Income|
You’ll notice that at lower income levels, the average person spends more than they earn. This is just the average, so not everyone making $44k a year is spending $47k.
It makes intuitive sense that people at higher incomes are able to spend a lower percent of their earnings (and, therefore, to save a higher percent), but I think there’s another reason as well. Namely lower housing costs.
One way of saying this is that people who save a high percent of their income are usually good at both offense and defense.
- Good offense = High income
- Good defense = Frugal spending, especially on housing (the biggest expense for most people)
It’s worth noting that the $50,000-$69,000 income range—the first range to spend less than they earn—spends 30.8% of their income on housing, on average.
You want to do both—increase income and keep costs down—but below $50k in income and housing spending above 30% seem to make it difficult to make ends meet.
My Housing Spending
My housing spending is very low as a percent of my income. I bought my house in 2015, which was a time of low prices. I bought in Gainesville, Florida, which is an area with low prices. It took me almost a year to hunt down the best deal possible.
It turns out the best deal possible was a 4/2 for $105,000.
My total monthly payment (principal, interest, taxes, insurance), is less than $600 a month. If I just look at my take-home pay from my salary (ignoring my inconsistent side hustle income), my housing represents less than 17% of my income. And that’s using some very conservative calculations that round up my housing payment to $600 and ignore my side hustle entirely.
So with a middling income, the percent I’m spending on housing is in line with people who earn far more income.
Buying vs. Renting
Since we’ve just been talking about the monthly housing payment, everything we’ve said applies to both buying and renting.
The main difference is that it’s easier to estimate the cost of renting, since your only expenses are rent and possibly renters insurance.
When it comes to housing, you’ll need to figure out the principal, interest, taxes, and insurance that will make up your total payment. You’ll also need to consider other fees such as HoA dues.
Calculating these involves other variables such as how large your down payment is. More on that in a second.
The best bet if you’re thinking of buying a house is to figure out the percent of your monthly income you’re willing to spend, then use online calculators to determine what the most you can pay from a home is (use a 20% down payment in these calculations).
The Case for a 20% Down Payment
If you have less than 20% equity in your home, your lender will likely make you pay Private Mortgage Insurance (PMI).
Well, having insurance is good right? It protects you from bad things that might happen.
In this case, PMI is insurance you buy for the bank to protect them against the risk that you default on your mortgage. In other words, you pay money and get…nothing in return.
The Rule of Thumb for How Much House You Can Afford
So putting our two lessons together, if you have enough cash to cover a 20% down payment (and closing costs), and your monthly payments (principal, interest, taxes, insurance, and other fees such as HoA dues) represent less than 30% of your after tax income, you can probably afford the house.
It’s also worth noting that you should plan on living there for several years as buying and selling incurs closing costs that you’d prefer to experience infrequently.
The less you can spend the better, but 30% of income serves as a good cap. Hopefully your income will climb from there, causing your house spending as a percent to fall.
I know that it’s difficult to find an affordable house, but lowering your housing expenses is a big win, and big wins aren’t easy.
Related Post: Big Wins the Simple Way: The 80/20 Approach to Saving Money
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