Written by: Corey Janoff
Most financial goals require one to accumulate wealth. If you want to retire, pay for your children to go to college, buy a house, or take a nice vacation, some level of saving is required. For some people, it is easier to accumulate wealth than others. I can generally tell pretty quickly if someone will have the ability to significantly grow their wealth over time. I can also tell pretty quickly if someone will struggle to accumulate wealth. There is one variable that is a very strong predictor of wealth accumulation.
Many people think a high income is the key to financial success. “If I could just earn X amount more each year, I will be able to achieve my financial goals.” Earning a high income can help you accumulate more wealth than the average American, but it doesn’t guarantee it. I know plenty of people who earn high incomes and live paycheck to paycheck.
Obviously having a high savings rate will help you grow your wealth. If you invest 25% of your income for your future goals, you will be more likely to achieve your goals than someone with similar income and goals who only invests 5%. But what determines whether someone will be able to invest 25% of their income or only 5%?
There are many variables that contribute to the ability to accumulate wealth, but I believe there is one single variable that has the highest correlation. That variable is housing costs. More specifically, the percentage of one’s income that is spent on housing.
Your housing costs will likely be your largest expense throughout your life. Therefore, the less you spend on housing, the more flexibility you will have to spend money on other things and save money for future goals.
There seems to be a line in the sand where the tipping point lies. People who spend less than 20% of their income on housing are far more likely to significantly accumulate wealth than those who spend more than 20% of their income on housing.
Housing Costs of the Affluent
Professors Thomas Stanley and William Danko spent their careers studying the affluent. You may recognize their names from the book they co-authored together, The Millionaire Next Door. In that book, they look at many traits of high net worth individuals; education, parent’s financial status, occupation, etc. They categorize people into two camps: Prodigious Accumulators of Wealth (PAW’s) and the Under Accumulators of Wealth (UAW’s).
The PAW’s are those who are able to accumulate wealth at a greater clip than their peers in similar income brackets. UAW’s are those who accumulate less wealth than their peers. One of the variables they look at is housing costs.
Stanley and Danko found that millionaires and people who become millionaires rarely carry a mortgage that is more than two times their gross income. Meaning, if a family earns $100,000/year and aspires to become millionaires, they should keep their mortgage balance below $200,000.
Now, Stanley and Danko were studying millionaires back in the ‘70’s and 80’s and published the book in the mid 1990’s. $1,000,000 during the time of their studies is probably closer to $2-3 million today. So, if you want to have a net worth greater than $2-3 million one day, carrying a mortgage balance of less than two times your income can help the cause.
Two Important Ratios
I encourage people to pay attention to two ratios when it comes to housing costs.
- Try not to have a mortgage balance much more than two times your income.
- Keep your housing costs below 20% of your income. One fifth of your income.
This is gross income before taxes, by the way. And the housing costs include rent or mortgage (principal & interest), property taxes, homeowner’s insurance, and HOA dues.
Two pretty simple ratios. The nice thing about them is they work together. If your mortgage balance is less than two times your gross income, your annual housing costs will almost always be less than 20% of your income (unless you have extremely high property taxes and HOA payments).
If you follow those two rules, then you are giving yourself a greater opportunity to accumulate wealth than most people. It also will give you some wiggle room to afford all of the various expenses that come along with homeownership.
Now, you might be shouting at your screen right now, “There is now way I can find a decent place to live for that price!”
I agree that housing costs are expensive, especially in major metropolitan markets. I’m simply laying out the numbers for you. Wealth accumulation is a math equation.
(Money Earned) – (Money Spent) = Money Saved
The more you spend on housing, the less you will be able to save. Or, the more you spend on housing, the less you can spend on everything else if you are saving enough to reach your goals.
House Sizes have Increased
Part of the reason housing is so expensive today is because we have demanded more expensive houses! The average house built today is 1,000 square feet larger than the average house in 1973! From a percentage standpoint, new houses today are 62% larger than they were back then. With families having less children today than they were in the 60’s and 70’s, the number of people per household has declined as well. This has resulted in the average living area per person to double since the early ‘70’s.
The inflation-adjusted price per square foot has remained fairly level over time. We are just buying more house than the generations before us!
We can complain about housing prices and how it’s difficult to find a decent house at an affordable price. However, our definition of what a decent house is has changed over time. Our standards have increased.
And yes, I understand that population growth in urban and suburban areas has created a double whammy effect in driving housing prices up significantly in certain cities. But if the demand is there, builders are going to build bigger and more expensive houses.
Banks Will Approve You for More Than You Should Buy
One thing that doesn’t help matters is how much lenders are willing to give borrowers to purchase a house. There are some exceptions, but banks will allow you to have up to 43% of your income going towards debt payments. If you are spending 10% of your income on a car loan and student loan, you can then spend up to 33% of your income on a mortgage. If you don’t have any other debt, a bank may lend you a mortgage with a payment equal to 43% of your gross income! Before taxes!
If you are spending 43% of your income on debts and your effective tax rate is 25%, that means you only have 32% of your income remaining for everything else! Food, utilities, cell phone, cable/internet, vacations, childcare, pets, clothes, haircuts, birthday/holiday presents. Oh, and don’t forget to save for your future goals. I generally advise people to save 20% of their gross income for retirement. Good luck.
The bank doesn’t care if you save for retirement, or go on vacations, or only eat rice and beans and the McDonald’s Dollar Menu. They just care about you making your mortgage payment each month. As long as you can pay your mortgage, they will lend you the money and threaten to repossess your house if you don’t pay it.
The Joneses Who Live Next Door
The other problem with buying more house than you should is the neighbors you will end up comparing yourself too. Not only are you stretching your limits to make your house payments, but you will have to spend even more money to keep up with the Joneses in your neighborhood. If everyone on your street is driving a new Mercedes, Lexus, or BMW, you are going to feel some internal pressure to upgrade from your perfectly adequate 8-year-old Honda.
Everyone seems to have beautiful landscaping in that nice neighborhood you managed to finagle your budget to buy into. And they all have landscapers who show up weekly to mow the lawn, prune the bushes, and weed the flower beds. You’re the only one on the street who still mows his own lawn. They talk about you when you’re not around.
However, if you spend less than 20% of your income on housing payments, you will probably be in much better financial shape than your neighbors. They are all driving 8-year-old Honda’s and mowing their own lawns. You don’t feel any pressure to spend on luxuries to keep up with them. If anything, you might feel a little ostentatious if you bought a fancy new car. The temptation to fit in with those around will work in your benefit as you continue to live a modest lifestyle while socking away all of your extra cash that you aren’t spending.
Exceptions to Every Rule
As with most things in life, there are exceptions to every rule. If you have a high likelihood of your income increasing in the future, you might be able to bend the rules a little bit now. I know people who spend more than 20% of their incomes on housing and are still able to save enough to reach their long-term financial goals. They're few and far between, though. I also know plenty of doctors who carry $300,000 in student loans and have three children and need to keep their mortgage balance well below two times their income in order to be on the right track financially.
Everyone has a unique situation and different lifestyles and financial goals. However, as I mentioned earlier, your housing costs will likely be your largest expense in your life. Partly because it never goes away! You are either paying rent or paying for a mortgage. Even when the mortgage is paid off, you still have property taxes, homeowner’s insurance, and home maintenance expenses.
Because it is likely your largest expense, the less you spend on housing, the more flexibility you will have with the rest of your finances, which will increase the odds of you achieving your financial goals. So, if you want the ability save a lot and become a Prodigious Accumulator of Wealth, start with how much you are spending on housing.