It is probably no secret that housing is the greatest expense for the majority of families in the United States. In fact, it has been the the largest expense for Americans over the past 70 years (taking the title from the food category, believe it or not).
Now, understanding that having a home is a primary need for families to live a comfortable lifestyle, we can get into the discussion of what is necessary and what someone can actually afford. I am comfortable recommending my clients spend 25-30% of their take-home pay on housing related expenses. However, it is more common for me to see people spending 40-50% of their take-home pay on housing. This has unfortunate consequences on how individuals can live their life.
The home has taken on a bit of a status symbol in our country. We often hear the phrase “Keeping up with the Joneses.” Comparing ourselves to our peers is a natural habit for just about anyone, myself included. The problem is, we don’t know anything about our peers. Yes, they bought a big house and brand new car, but this does not have any correlation to their income or overall financial health (or happiness!).
When strapping yourself with a large housing expense, you cannot help but put pressure on other areas of your finances. For example, a family that has a gross annual income of $100,000 will take home about $5,600 per month after taxes, 401(k) contributions, HSA contributions, and other general deductions. This family should be spending a maximum of $1,680 per month on housing expenses, preferably closer to $1,400.
What if this family realized they were perfectly comfortable living in a slightly smaller house and more affordable neighborhood? Their monthly housing expenses could be dropped down to $1,000 per month. This can free up about $500 per month ($6,000 per year) for discretionary spending!
I don’t know about you, but taking your family on an international vacation every year sounds like an experience worth remembering.
Now, I have an even crazier idea. What if you took the money you are saving by living in a more affordable home and put it towards your retirement savings? This is how you begin your journey to financial independence.
Consider a 15-Year Mortgage
The most popular mortgage payment schedule is 30 years. Why? Because when you pay a mortgage over a 30 year period, your monthly payments are smaller, allowing you to think you can buy more home!
I challenge you to consider taking out a 15-year mortgage instead of a 30-year. Let’s take a look at the numbers:
For a $200,000 mortgage at a 4% interest rate, the 30-year payment schedule will require a $955 payment each month, for a total of $343,800. For the same mortgage, a 15-year payment schedule will require a $1,479 payment each month, for a total of $266,220. A savings of $77,580!
Now, there is another way to look at this. Conventional wisdom says to take out a mortgage over 30-years, because with interest rates at 4%, your money will grow more if invested instead of put towards paying down debt. Yes, this is very true. However, the majority of people that talk about this strategy never actually invest that money (SPOILER: they spend it!).
I’m not talking about conventional wisdom here, because the fact is that the majority of people are not good at saving their money and sticking to an investment strategy.
Remember, a 15-year mortgage will increase your monthly payment compared to a 30-year mortgage, meaning you will need to look at purchasing a less expensive home to keep within your monthly budget target of 25-30%. A 15-year mortgage is a great way to “trick” yourself into purchasing a less expensive home and creating a greater life for yourself.
Retire Mortgage Free
Purchasing a more expensive home than you can truly afford puts additional pressure on your ability to retire. Not only will a large mortgage payment put constraints on your current cash flow, it also increases the amount needed to be saved up for a successful retirement.
For example, if you have a mortgage payment of $2,000 per month, you will need $600,000 in retirement investments just to fund the mortgage! This doesn’t even include the increased property taxes and insurance from owning a more expensive home.
To calculate how much you need to fund your expenses in retirement, multiply your annual expenses by 25 (in this example - $24,000 x 25 = $600,000). This is the amount you can conservatively assume will fund your retirement expenses using the 4% Safe Withdrawal Rate. Meaning you can withdraw 4% of $600,000 per year in retirement, plus inflation increases, and have the account last indefinitely.
As you can now see, carrying a $2,000 monthly payment into retirement will require you to save up a significant amount of money in your working career in order to maintain that same lifestyle during retirement.
By initially purchasing a less expensive home, you will be able to pay off the mortgage quicker, allowing you to retire mortgage free.
To wrap this all up, you can take this mindset of “smaller house, greater life” into all aspects of your personal finances. When thinking about buying that new car for “only $399 per month” or spending $200 per month on your cable bill, know that it doesn’t have to be that way.
Spend time to really consider what makes you happy. Is the larger and more expensive home really going to bring you more happiness? Or will having the ability to pay all of your bills on time, save for retirement, and take trips around the world with your family (simultaneously) bring you the most joy?
I challenge you to think about this concept and know that it’s never too late to make changes in your life.