Buy a House and Cars You Can Afford
As a part of the Millionaire Rules series it is important to address the two largest purchases most people make in their lives. The choices you make about where you live and what you drive can drastically effect your long term ability to create wealth. If you allocate too much money to these budget items it is almost guaranteed that you will find it difficult to save and invest for the long term. A lifetime of fugal living, epitomized by the "latte factor" is quickly dwarfed by these two massive financial commitments.
I am not sure if these terms are universally used, but where I'm from it was common to hear someone called car-poor or house-poor. Contrary to what you might expect, it is NOT someone who lives in an ugly house or drives an ugly car. Instead, the term refers to someone who has stretched themselves too thin by buying a house or car they truly can not afford. All too often the explanation for a friend's absence at a party or night on the town was because of our friend's car-poor status. Even worse than missing out on the social scene, if your goal is to build wealth, overextending can be a giant mistake.
The purpose of a car is to provide transportation. This is important because so many people try to think of their car as an expression of themselves. If you are an outdoors person you should drive a Jeep, if you are eco-friendly you should drive a hybrid, if you are a macho man you should drive a big truck, and if you are a young professional you should drive a Infinity, BMW, or Mercedes. With no exaggeration, this mindset can ruin your long term hopes at building wealth.
In some locations transportation is best served by avoiding cars all together and using public transportation. I've spent time in several cities where this is by far the best way to get around. In other places, there is no way around owning a car. Unfortunately, I fall into this category myself. However, when I visit New York City or Chicago, you had better believe that I use public transportation whenever possible. It saves money, frustration, and time in most big cities.
If owning a car is a necessity, it is important to know that the value of your car falls rapidly from the moment it is driven off the dealer's lot. Some cars loose 30% of their value in the first year alone. Knowing this, it is often wise to buy a used car where someone else has suffered this massive initial depreciation so it does not hit your bottom line. Another alternative is to buy a new car, and then literally drive the car until it is ready to be sold for scrap. The benefits of this method are to spread the depreciation over the full life and mileage of the car, and it ensures the the car had not been abused or poorly maintained by its previous owner(s).
Now, the million dollar question. How much to spend on your car to begin with? If it isn't a status symbol or personal expression piece, it should be pretty simple to find a safe, reliable car with room for four people and some luggage brand new for around $15,000. If you want to buy a used car, great low mileage cars in good condition can be found for half of that amount. A person striving to become a millionaire has no business driving a car that costs half of their salary or more. If you make $50k do not buy a $25,000 car! If you make $80,000 do not buy a $40,000 car!
A rough rule of thumb is that your car payment should never be more than 5% of you salary on a 48 month loan. Based on a loan at 6% and a 20% down payment this works out to be a $4,375 car for someone who makes $20,000, $10,700 for someone at the median income of $48,200, and $22,200 with an income of $100,000. How do you stack up? This is of course, if you finance the vehicle at all. Alternately, if you are already well on the way to wealth, spending about 1% of your net worth would be an equivalent rule of thumb.
Now to talk about housing. First of all, do not buy a house if it is cheaper to rent an equivalent house. Run some numbers about how much it will really cost to own and make a well informed, educated decision. When dealing with housing it is important to realize you will have to make the payments for 360 months to pay the mortgage in full. Other than marriage, this is the longest commitment most people ever make.
The old rule of thumb was to buy a house that was equal to 2.5x your salary. This rule has been updated somewhat to account for lower interest rates, and now the rule is to spend less than 30% of your gross income on your home. In most cases a mortgage that is 28% of your income fits the bill. To put this in perspective, on the $48,200 median income a person should hold a mortgage of no more than $192,000 assuming a 5.75% interest rate. A sizable down payment of at least 10% is also prudent, to establish a reasonable price ceiling of $213,000 for the purchase of a home.
Next, we should also consider how much space is needed. It is a waste to buy more house than is necessary to live comfortably. A rough approximation of 1,500 sq ft for a family of four and 1,200 sq ft for a couple is what I would recommend. This is about 30% smaller than the median American home but should still meet all of the basic needs. Buying less house frees up money for saving, investing, and building wealth.
Contrary to common wisdom, it is poor financial advice for your home to be your largest "investment." Homes typically appreciate at roughly the same rate as the economy as a whole, where as stocks produce a much larger return. Ideally it will be possible to invest far more money each month than is spent on housing costs. Every dollar you save instead of spending on housing will be able to compound and build much more wealth than if it were tied up in a slowly appreciating house.
If you are willing to make wise purchases for these two large budget items, it will go a long way toward building wealth. It can take a life time of pinching pennies to amount to the benefit derived from a single thrifty choice when buying a home or picking out a car. Be sure to think long and hard before making the type of commitment that has the potential to either take you leaps and bounds toward becoming a millionaire or instead leave you car-poor and struggling.
by Ken Fisher.