Question the norm
I learned from the number 2 Financial Planning program in the country (at the University of Georgia) to use 30% of net income as a rough guide when talking to clients about home purchase price.
30% is a very big number.
I’m not bashing my school. I’m bashing the norms of the masses. How can we justify devoting such a large portion of our incomes to housing? The only reasonable explanation might be “It’s an investment.”
But when you do the math – not so much.
The average appreciation on home values is about 6%. The average annual interest rate, though, pretty much offsets that amount over the life of the loan (not to be confused with the term), which is primarily interest the first 15 years of a 30-year mortgage.
I don’t know when the break even point is but I’d guess it was after year 20. Rental property is another story but your primary home should not be bought because it’s an “investment” – because it’s not a very good one.
But you get a deduction!
The deduction in and of itself won’t make it worth your while. That’s because tax plays are only plays if it’s a break on an expense you’re already paying for. The entire tax code is written to incentivize citizens to behave the way our government wants us to behave. It’s a stimulus plan at your expense.
Here’s a neat trick
Something else I learned at UGA was the power of compounding interest. Compounding interest is interest earned on your investments on top of interest that has already been earned on your investments. This, I agree, is very, very powerful – especially when you’re young.
Here’s an example of compounding interest. Let’s look at a $20,000 investment earning 6% annually. Person A invests that $20K for a 20-year term; Person B for 50 years. How much would each have at the end of their respective terms?
Each one spent $20,000. Person A will have $66,000. But Person B will have nearly $400,000! That is the power of compounding interest at work.
Spend less, earn more, enjoy life
Let’s use another example to tie all this together.
A young couple gets married. They’re 27 years old and each earn about $50,000 (call it net income to keep it simple). If, instead of keeping up with the Joneses and spending 30%+ of their income on a nice house, plus a car and all the other crap most people think they need – instead of that, let’s say they keep their jobs and live out of a bus or tiny home until they’re 35. They pay for everything in cash and live on $3,000 per month.
$100,000 net income – $36,000 expenses = $64,000 extra every year.
I think they can afford to pay for everything in cash 🙂
So what do you do with that extra $64,000? Invest it and earn compounding interest. How much would they have at age 35 if they did this?
$640,000. And that’s earning only a modest 6% interest – the average equity investment blend is closer to 10%.
What if they decide they can live in a tiny home until 45? Well, then they’d have about $2 million in the bank. Do you think they’d be able to retire at 45 with $2 million in the bank when they’re used to a $36,000 lifestyle? I think they’d probably be able to retire before 40.
If you’re young, live as cheaply as possible and invest as much as possible. And if you’ve got it in you, create a few passive income streams in the process. This is how you retire early. This is where freedom is.
“Enough” money is relative. Your mind is the only limitation.
Find out more about Derek Cobia at The Frugal RVer.
All photographs courtesy of Derek Cobia.