Guest post by Brian Davis
According to a recent analysis of data from the U.S. Bureau of Labor Statistics, the average American spends 70% of their income on just three things: housing, transportation, and food.
No wonder North Americans are saving so little.
The household savings rate in the US was 3.8% in the first quarter of 2017. In Canada it was little better, at 4.3%.
More than a third of working-age Americans have no savings at all. Another 35% have less than $1,000 in savings. That begs some uncomfortable questions: What would happen if a sudden health issue popped up? Or they lost their job? Or even had a hefty car repair bill?
Before any Canadians catch a case of the smug, consider that half of Canadians are now living paycheck-to-paycheck.
According to a recent analysis by Deutsche Bank, middle-class families spend half (!) of their income on luxuries. The study found that even low-income families spent 40% of their income on luxuries.
So, what can the average family do to become, well, less financially average?
How One CFP Recommends Breaking Down Expenses
If 70% of your income is too much to spend on housing, transportation, and food, then what’s the right amount?
In Rules to Riches, Certified Financial Planner Mark Baird details exactly how families should break down their budget if they want to build wealth. And I’ll tell you right now, you won’t like it.
For a middle-class household, Baird recommends spending no more than 15-20% on housing.
Transportation? No more than 10% (preferably closer to 5%). Gas, insurance, parking, maintenance, repairs, and of course the car itself – all fall under the “transportation” umbrella.
And cap food at 5-10% as well (that includes beverages, for those of you who enjoy a glass or three of wine!).
For the mathematically disinclined, that comes to a hard limit of 40% for housing, transportation and food. Preferably those numbers are closer to 25-30%.
How do the rest of the numbers break down?
Savings & Investments: 5-20%
Personal Care & Cash: 2-4%
Medical & Dental: 3-5%
Education & Self-Improvement: 1-2%
Entertainment, Dining, Gifts: 2-4%
Vacations & Holidays: 2-4%
And of course taxes. The tax man will get his cut, no matter what.
Before going any further, we get it: some housing markets are expensive. Readers in Toronto and New York are balking, mouths open in disbelief, at the idea of spending 15-20% of their income on housing.
They’re not alone; so are readers in San Francisco, Vancouver, Seattle, Washington DC, Boston, Montreal, San Jose, Los Angeles, San Diego, Chicago… need I go on?
Housing is expensive in and around large cities. But that doesn’t mean that every urban dweller spends 40% of their income on housing.
Here’s the thing about budgets: they’re a zero-sum game. If you spend 35% of your income on housing, that’s money that you can’t spend on clothing, or entertainment, or food, or whatever.
The problem is that most people pull that money from their savings. It’s the easiest, lowest-impact place to pull money from, at least in the short term.
In the long term, it means less financial security, longer working years, and less wealth.
Rule #1 for budgeting is set your savings rate before determining all other expenses, and make it the first expense to go out every time you get paid. If your target savings rate is 15%, then on every payday, a transfer of 15% of your paycheck should go straight to your savings/investing account.
How to Save on Housing
The least fun way to save money on housing is, of course, to just move into a less expensive home. If you don’t have any savings thought, this is a good place to start. Avoid the rat-race question of “What’s the most I can afford to spend on a home?” and instead ask “What’s the least expensive home I can still be happy in?”
But living in a less expensive home is far from the only strategy to save on housing. You could buy your dream home, and then simply rent part of it out to a housemate. It could be a room, or it could be an income suite – a semi-segmented portion of the property where the renter has more independence and privacy.
Better yet, you could house hack with a multi-unit property. House hacking involves buying a 2-4 unit property, moving into one of the units, and using the rent from the other unit(s) to cover the mortgage. In other words, you get to live for free.
It’s not magic. I interviewed a house hacking newbie named Tim a few months ago, an ordinary insurance underwriter who bought a duplex earlier this year. The rent from his neighbor pays the mortgage, with enough left over to cover maintenance and repairs for the whole property.
Score one for the “work smarter not harder” contingent, although it still takes discipline not to spend that extra money saved on housing!
Saving on Transportation & Food
The average car loses 25% of its value within the first year of ownership. Does that mean that a one-year-old car is 25% slower than a new car, or 25% less safe, or 25% less reliable?
No. It means it doesn’t have the famed “new car smell,” and you don’t have 100% certainty about how many oil changes the car got in its first 12 months.
Nearly half of millionaires only buy used cars. Surprised? You shouldn’t be. It’s this frugality that helped them save and invest enough money to become millionaires in the first place.
Or better yet, skip the car altogether and bike to work. Mr. Money Mustache once said, “Bikes save money and run on fat. Cars cost money and make you fat.” It’s hard to argue with that logic.
As for food, try to cut out all meals not prepared at home. That includes lunches! Pack your own.
Try this challenge: don’t eat out until you’ve eaten or thrown out every single item that’s been in your refrigerator, freezer or pantry longer than a week. Most people are shocked when they discover just how much food they’ve simply forgotten about.
Keeping Up with the Joneses Is a Race to the Bottom
We all like spending money. We love to show off how successful we are, how stylish we are, how good our taste is and how sophisticated we are.
Except all that showing off is a good way to go broke.
If you want to create true wealth, lasting wealth, spend a third of your income on housing, transportation, and food.
Let your friends show off their huge homes and fancy cars. They probably have less than $1,000 in savings, while you’re saving 20% of your income and starting to earn compounding returns and passive income. That’s where real wealth comes from: investments and passive income, not conspicuous consumption.