Save 10 percent of your pay
Spend no more than 25 or 28 percent of your take home pay on housing
Spend no more than 10 percent of your take home pay for a car lease, or 15 percent for a car loan
These are some readily available tid bits of advice if you’re doing some Google research. I’d even go so far to say that they are ‘industry standard’.
It’s as though there are two parallel worlds in the personal finance industry. First there are the celebrity advisors that have bestselling books, make regular TV appearances, have their own TV shows, or just popular web/podcast presence. They get their brand of personal finance out to millions of watchers and listeners.
Then there’s the FI community. Almost an underground secret handshake community that takes a lot of that mainstream advice and flips it around.
Not all the canned advice is bad. However, it’s aimed at the majority of our population that spends too much, saves too little and takes on unreasonably large amounts of debt. So if you’re trying to reach millions of Americans then chances are the majority of your audience is living in debt.
This canned advice stinks though for those of us that just want to get ahead, gain financial independence, and pursue our passion. It’s the “getting ahead” part that turned me on to FI in the first place.
Housing and cars tend to be the highest cost items in a typical personal finance budget. Let’s take a look under the hood and see what happens when we apply it.
Case Study 1 – A high income family follows canned advice
For the this case let’s assume a dual income/no kids (DINK) couple. Both are in their 40’s, have professional careers, and bring in $240,000 ($20,000/month) after taxes. This may sound high but is not unreasonable for two career professionals, living in a major metropolitan area that each have six figure incomes.
We’ll apply the canned advice percentages to this $20,000 monthly income as follows.
Housing using 25% of monthly income
A general rule of thumb that I found online is to have a mortgage payment anywhere between 25% and 28% of your monthly take home pay. We’re pretty frugal here since this is a personal finance blog, so I’ll just use 25%.
So for a take home pay of $20,000/month will equate to a monthly mortgage payment of $5,000.
I used the Mortgage Professor calculator to reverse calculate the price of a home based on these payments. Using an interest rate of 4% for a 30 year fixed rate mortgage, I came up with a house value of roughly $1,050,000. I also assumed no down payment, just to make it easy.
In Dallas, a home in this price range will be around 3,500 to 5,000 square feet. Right now the average home size in the US is around 2,500 to 2,600 square feet or half the size of our 5,000 square foot house.
This amount is also just the principal and interest portion of the mortgage, exclusive of taxes and insurance. The property taxes in Dallas are pretty high, somewhere around 2 to 2.5 percent of the value of the home.
So for a home in this price range, the taxes can easily be $25,000 per year….or $2,083/month in taxes!
I would estimate home owners insurance for a large home like this (and full of stuff) to be in the neighborhood of $4,000 annually or about $333/month.
Of course we can tack on cost of ownership, utilities, maintenance and such. Again, here in Dallas, it’s hot in summer and the heat tends to stay around a while, which means electricity bills run pretty high.
If it costs me $250 in July to keep my 2,400 square foot house cool, how much does it cost a 4,000 or 5,000 square foot house? A heck of a lot more would be my guess.
Here’s a very simple breakdown of housing.
| Monthly take home pay after taxes | $20,000 |
|---|---|
| Monthly mortgage Payment at 25% | $5,000 |
| Monthly property taxes (Dallas) | $2,500 |
| Monthly home owners insurance (estimated) | $333 |
Cars using 15% of monthly income
Besides housing, cars tend to be the the next biggest expense people encounter in their personal finances.
My simple Google research led me to this advice: have a car payment no more than 15% of your take home pay. If you lease then have a monthly lease payment of no more than 10%.
I’m personally not a fan of leasing. The thought of living with what is essentially a constant car payment is just not appealing. Therefore I’ll run this example with the 15% number.
For our income, we should be able to afford a car payment of $3,000 a month.
I used the same calculator to reverse calculate the car value. I used 3.1 percent interest and a 60 month loan and got a car value of approximately $167,000!
…will $167,000 get you one of these?
You can go through the same thought exercise here as in housing. Big house = more utility cost = more maintenance = more stuff to fill it with.
Expensive car = higher insurance cost = higher maintenance cost.
| Monthly take home pay after taxes | $20,000 |
|---|---|
| Monthly mortgage payment at 25% | $5,000 |
| Monthly property taxes (Dallas) | $2,500 |
| Monthly home owners insurance (estimated) | $333 |
| Monthly car payment at 15% | $3,000 |
| Remaining take home pay | $9,167 |
Case Study 2 – Canned advice with an FI twist
I thought it’d be a fun exercise to see what it would look like to come at the housing/car payment advice from a different perspective.
How about we cut our monthly numbers in half with the assumption that half of this money will be saved and invested, and we’ll run the same percentages from Case Study 1 on this amount.
Housing after saving half
A monthly income of $20,000 minus $10,000 for savings and investments, gives a new monthly income of $10,000 (geologists actually can be good at math…).
The new monthly house payment is now between $2,500 to $2,800. Using that same spreadsheet from the mortgage professor I got a house value of between $525,000 and $590,000 (no down payment factored in).
For this amount of money you can get a three or four bedroom house under 3,000 square feet, either in the City of Dallas, or you can get more if you get out to the suburbs.
Taxes still run high, around $12,000/annually, but you’re saving half of your income in this example.
| Monthly take home pay after taxes | $10,000 |
|---|---|
| Monthly mortgage payment at 25% | $2,500 |
| Monthly property taxes (Dallas) | $1,000 |
| Monthly home owners insurance (estimated) | $200 |
Cars after saving half
A monthly after tax income of $10,000 x 15% is $1,500 for a car payment.
Even for two cars, $1,500 still does not sound realistic to me. You could probably finance two Ford Raptors on that amount.
| Monthly take home pay after taxes | $10,000 |
|---|---|
| Monthly mortgage payment at 25% | $2,500 |
| Monthly property taxes (Dallas) | $1,000 |
| Monthly home owners insurance (estimated) | $200 |
| Car payment at 15% | $1,500 |
| Remaining take home pay | $4,800 |
Case Study 3 – Family with combined after tax income of $100,000
For case study three let’s just cut to the quick and show in a table what it would look like for a family with a household income of $100,000 after taxes.
| Monthly income after taxes | $4,167 |
|---|---|
| Monthly mortgage payment at 25% | $1,042 |
| Monthly property taxes (Dallas) | $500 |
| Monthly home owners insurance (estimated) | $100 |
| Monthly car payment at 15% | $625 |
| Remaining take home pay | $1,900 |
This is a little more tricky. From what I have observed, a lot of people in this range have a desire to live like the Case study 1 or 2 family. They get there by taking on massive amounts of debt and just acknowledging they will work forever.
If you take the 50 percent savings model and apply it here, housing is going to run about $1,166/month. The home price here would be $245,000.
In Dallas, $245,000 would get you into an older condo or townhome. Just looking on Zillow, some are not too bad, they just aren’t the new flashy ones.
The car payment is $1,250 for a monthly income of $8,333 or $625 if you’re saving half. Again, way too high.
Now this is an FI vehicle
The car payment is sky-high and not realistic. Fifteen percent is a lot.
Stepping back I think the housing percentage of 25% is realistic if you apply that percentage to half your pay.
Grow into 50 percent
My case studies use relatively high incomes.
My starting salary in the late ’90’s was $31,500. Saving 50 percent was not going to happen at that time. As a matter of fact, it would take over a decade before I could reach that amount.
For others it just boils down to how frugal you can be versus how much you can make. If 5% is all you can save, than save that until you can make more.
Another way to take this information is to calculate numbers that make sense. Where do you want to live, what do you want to drive. You can then back out how much money you need to make and have the lifestyle you want. Grow into that lifestyle while at the same time resisting the urge to upgrade past it.
The thing that worked best for me was auto pilot savings. Starting out small and incrementally adding to my savings over time.
Analyze Before You React
In 2002 we were told by a mortgage broker that we could afford a $450,000 house. We ended up buying a $150,000 house. Our peers? Many of them took the $400K option. Similar story with cars and other things.
We would not be where we are today had we taken the advice of only spending 25% on housing and 15% on cars. We owe a big thanks to the authors of The Millionaire Next Door because we read that book in 1999 and it changed our way of thinking early on. We may have saved a mere 10% of our income in our 20’s, but we knew that we had to save more to get ahead.
We also saw how the price of the house is just the beginning. Bigger houses need more things to fill them with, so it’s a snowballing process. We recognized that more stuff is more stress, and more problems.
The celebrity financial advisors can connect with millions of people easily because there are no shortage people with little savings or high debt.
Bottom line, be careful who you get your advice from.
Canned advice from the celebrity financial advisors isn’t all bad. Like anything, it requires an added element of critical thinking to make sure it’s suited for you.