To Reduce Expenses, Focus On The Big 3

If you’re trying to earn your freedom, you need to save a huge percentage of your income, somewhere on the order of 50%.  To do this, you need to reduce your expenses significantly.  Foregoing your daily coffee, while important, is not really going to cut it.  You need to make large sweeping slashes in the big ticket categories.  I call these The Big 3: housing, transportation, and food.

According to the Bureau of Labor Statistics, the average American household makes $70,000 per year and spends a total of $56,000 per year.  Of this total spending, $18,000 goes to housing, $10,000 goes to transportation, and $7,000 goes to food.

Those 3 categories comprise over 60% of total spending.  So, if you want to get serious on cutting expenses, focus on housing, transportation, and food. Here’s how to do it.

Don’t Be Afraid To Move

Depending upon where you live, housing costs may either be manageable or ridiculous.  For example, the average 1 bedroom apartment in Wichita, KS costs $470/month, but in San Francisco costs $3,600/month.

If you live in San Francisco, Manhattan, Boston, Washington DC, San Diego, or Seattle and you don’t have an income exceeding six figures, you might want to move to a new city, because housing costs, by themselves, are going to eat up 50% of your income.  There’s nothing wrong with moving away from a place you love temporarily to jumpstart your savings.  Use geographic arbitrage to your advantage.  You can always move back once you have the means to support yourself in an expensive city.

Renting is Okay

The decision of whether to rent or buy is complicated and involves both emotional and financial considerations.  You could write an entire book on this subject.  Suffice it to say, there are no absolutes on whether one is cheaper than the other. If you’re just getting started in a certain area, it is often prudent to rent for a few years to get acquainted with the area and make sure your job is stable before jumping in to a home purchase.

Focus on What you Need, Not What You Want

Regardless of whether you decide to rent or buy, you should focus on living in a place that is safe, functional, and modest but not extravagant.  If you are single, a studio will suffice.  If you are married, a 1 bedroom is more than sufficient, and if you have 2 children, you can probably make a 2 bedroom work.  You do not need a 5 bedroom mansion.  It doesn’t matter if the bank says you can afford a $400,000 house with your $70,000 per year income.  They are incentivized to sell you a more expensive house so that they make more in interest payments. Focus on what you can afford, not on what someone will loan you.

Use The 1/3  Rule For Housing

Speaking of what you can afford, there are a variety of rules to help you determine how much of your monthly income should be devoted to housing costs.  There are even calculators to help you determine how much house you can afford.  I recommend that housing costs (mortgage, insurance, property tax, and utilities) make up no more than 1/3 of your take-home pay after saving 50%.  Remember, if you’re doing it right, saving (or paying off debt) comes before any other spending.

Examples of Using The 1/3 Rule

Let’s see how that works out for an average household income of $70,000.

If this is a married filing jointly household with two earners, they can save 50% right off the top by contributing the max to their 401ks ($36,000 per year).  This leaves around $34,000 in adjusted gross income, which will only result in a federal tax liability around $1000 after the standard deduction and personal exemptions.

Of course, they will still pay payroll (FICA) taxes of $5,300 (7.65%). So let’s assume an annual take-home income of around $28,000.  This will be equivalent to a monthly take-home income of around $2300.  Using the 1/3 rule, no more than $800 per month should be devoted to housing.  Extreme?  It depends upon where you live.

Earning your freedom by saving half is not easy, but this could also be motivation for increasing your income. If you have a household income of $100,000, you will pay payroll taxes of $7650 and have a federal tax liability around $5000 after maxing out 401ks. Your take-home pay would be around $51,000 ($100,000 – $36,000 – $7,650 – $5,000). Remember, to save half of your gross income, you would need to save $50,000 total, or an additional $14,000 (ideally in Roth IRAs).  So after saving 50%, your take-home pay would be $51,000-$14,000 = $37,000 / year, or $3,100 monthly.  The 1/3 rule results in a goal of no more than $1000 per month to housing.  Still challenging but a bit more reasonable.

Exceptions to the Rule

The 1/3 rule works well in low to moderate cost of living areas.  If you live in a high cost of living area, you may need to increase the percentage of your take-home pay devoted to housing, perhaps to 50%, but if you do this, you will need to cut down on other areas, like transportation and food. When you’re saving 50% of your gross income, there’s not a lot of room for fluff spending.

Buy Your Car With Cash

If you can’t afford to buy a car with cash, then you can’t afford the car.  Financing has become commonplace but we need to reverse the trend.  The average American spends $10,000 per year on transportation.  Over the course of a 45 year time period, if this $10,000 per year was instead invested at 5% real return, it would result in nearly $2 million, enough to support a great retirement.

My recommendation is to buy a car with cash and keep it for at least 10 years.  If you make $30,000 per year, this might be a $5,000 used car.  If you make $200,000 per year, this might be a $25,000 new car.  Both are reasonable at those extremes of income.  If your car is fully paid-for, then your main transportation costs are gas and maintenance, perhaps $2000 per year for 2 cars, a much more manageable expense.  Whatever you do, don’t finance a car you can’t afford, and don’t fall into the trap of buying a shiny new $30,000 car every few years.

Limit Eating Out

The quickest way to blow up a food budget is to go out to eat.  My wife and I went out to Moose’s Tooth last night.  It’s a great place. We ordered a large pizza and each had a beer.  After the tip, the total came to around $50.  That’s nearly one-third of our entire food budget for the week.  Yes, it was worth it, but we try to limit our eating out to once or twice a month for that reason.   The average household spends $3000 per year eating out, or around $250 per month.  Don’t be average!

Cook Your Own Food

One of the reasons many people go out to eat is that they don’t have the time or energy to make their own meals.  I recommend that most people try some form of meal prep so that their main meals are prepared ahead of time for the week.  With an upfront effort of about 3 hours, you can make nearly all of your meals for the week.  If you can grab a Tupperware meal and bring it to work each day, you’ll be less tempted to go grab a $10 meal at the local Panda Express.  When you get home after a busy 12 hour work day, you can just grab a Tupperware rather than go out to Moose’s Tooth.  Meal prep can be intimidating, but I’ll explain some strategies in detail in an upcoming post.

Summary

If you want to get serious about reducing your expenses, you need to focus on the categories that are most likely to blow up a budget: housing, transportation, and food.  Limit housing to what you NEED (not what you want), use the 1/3 rule, buy a modest car with cash, limit eating out, and cook your own food.  If you can do those things, you’ll be well on your way to saving 50% and earning your freedom.

Remember, it’s NOT about the Money; It’s About the Freedom