For many people, housing is their biggest expense. That’s true for me too and it was especially true when I lived in San Francisco. In the Bay Area, I spent an outrageous amount of money on rent. My coworkers in the Bay Area all did; San Francisco is the most expensive rental market in the United States. Paying the rent was painful. But it taught me that getting your housing spending right is the key to healthy finances.
One way to determine how much to spend on housing is to ask “what’s the maximum rent or mortgage I can afford to pay?” and then to go shopping for apartments or houses that cost that maximum amount. I think this reasoning is backwards. When you choose to spend as much as you can on rent or on a mortgage, you guarantee that you won’t be able to save much unless your other expenses go down or your income goes up.
On top of that, because housing is such a big expense, differences in rent or a mortgage that can seem small now have huge effects on your finances over decades.
For instance, let’s say you are looking to rent an apartment. You might find one apartment you like that rents for $1,000 a month and another that you like better that rents for $1,200 a month. It can then be tempting to tell yourself that if you’re going to pay more than a thousand dollars a month on rent, you might as well rent the apartment you like best. What’s an additional $200 on $1,000?
But what happens if you were to choose the cheaper apartment and instead invest those $200 a month? Let’s say you’re 25 now and you plan to retire at 67. If you invest $200 a month in stock index funds and get reasonable returns of seven percent per year, you can expect to have over half a million dollars when you retire! Which would you rather have: a slightly nicer apartment or half a million dollars when you retire?
There is no right choice and no wrong choice, but I hope the example illustrates just how important it is to think carefully about how much you want to spend on housing.
(For those interested in the calculation: I assumed investing $200 x 12 = $2,400 yearly and I did not adjust for expected inflation. That leads to $548,549. Adjusting the seven percent long-run rate of return on stock index funds for expected long-run inflation, we can use a five percent rate of return and end up with $319,636 in today’s dollars instead. I did not account for taxes.)
Here’s an alternative way to think about the importance of what you spend on housing. If you would like to save money, but find it difficult when the time comes to spend or not spend, you could help yourself by reducing the number of times you have to decide. Housing, and in particular a mortgage, is the ultimate expense that you sign up for once and then deal with for a long time.
Let’s say you like to eat out and usually spend around $50 when you do. If you want to save an extra $100 a month, then twice a month, you’ll have to tell yourself “no, don’t eat out tonight”. That might be difficult when a friend asks you to meet for dinner at your favorite restaurant. But if you decide, when you look for housing, to rent an apartment that’s $100 a month cheaper than another apartment you considered, you accomplish the same savings. The cheaper apartment might be slightly less nice in some way, but you’ll only have to tell yourself “no” once: when you sign the lease.
When I moved to San Francisco, I knew I’d have to pay an extreme rent. I came to love the city, making it easier to forget how expensive it is. But eventually I had a hard time convincing myself that paying the outrageous rent was okay. Then I ran the numbers on how much more I could save and invest by living in a city with normal rents. Now I don’t know if I can ever justify paying such a high rent again. No matter how little I could spend on other things, spending that much on housing would destroy my personal finances.
How much you spend on housing, more than anything else, determines how much you can save each month. Get it right.