The Most Important Spending Decision You’ll Ever Make

August 11, 2011

Last week, I discussed the concept of the blog EarlyRetirementExtreme.com, in which you can be financially independent in 5 years by saving about 75% of your income. In the next series of posts, I’m going to share ideas of how you can save money in each area of your budget, with real life examples from my own life.

Let’s start with the decision that probably has the largest impact on your budget. Whether you’re in a position that allows you to work from anywhere, looking to change jobs, or about to retire, one of the most important financial decisions you will make is where you choose to live. That’s because it affects two of the biggest items in most people’s budgets: their taxes and their housing costs. Financial planners talk about your housing expenses as a “fixed cost,” but it usually isn’t really fixed. The fact that it’s relatively difficult to change, just makes it even more important to get it right.  So, in addition to all of the personal lifestyle issues (like jobs, proximity to family and friends, climate, culture, and things to do) that we usually focus on, here are some additional financial issues to consider when choosing  a place to call home:

State Taxes

You can’t escape federal taxes (at least not legally without leaving the country and renouncing your citizenship), but you can escape (or at least reduce) state ones. For example, I paid about $500 a month in CA state income taxes last year that I wouldn’t have had to pay in a state like Texas, Florida, or Nevada that doesn’t have a state income tax. I don’t know about you, but I can think of a lot of better things to do with an extra $500 a month. The funny thing is that the sales tax rate is actually about the same in those states. Are the public services we get in California really that much better? Probably not, but we did have “The Governator.”

Cost of Living

Taxes aren’t the only price I pay for living in sunny San Diego. The cost of living can vary considerably from city to city, so before you accept that high paying job, you might want to see how far those extra dollars will really take you. (But if you’re moving to a place with excellent public transportation like NYC, don’t forget to offset the higher housing costs with what you can save by not needing a car.)

Rent or Buy?

With interest rates and housing prices near record lows, it may seem like the right time to buy, but that isn’t necessarily the right decision for you. One of the reasons is that closing costs can eat up any benefits from buying if you don’t keep the property long enough. You also have to factor in how much you could earn by investing the extra money you save each month by renting, and how much you might have to spend fixing and maintaining the property. To put all these factors together, check out this nifty calculator to see how long it would take to make buying worth it. In my case, high housing prices relative to rent in San Diego, my desire to stay flexible and mobile as a relatively young bachelor, and the fact that I feel much more comfortable investing more in my mutual funds than being a handyman, all add up to make me a renter… at least for now.

Your Housing Budget

A rule of thumb that you often hear is to spend no more than a third of your after-tax income on the sum of your rent or mortgage payments, utilities, and if you want to buy a home, and any other costs of being a homeowner. But what you can afford really depends on what’s going on with the rest of your budget. Do you have a lot of debt? What other mouths do you have to feed? How much do you like to spend on shopping, eating out, travel, and entertainment? Remember that the less you spend on keeping  a roof over your head, the more you have to spend on other things and save for the future (like a down payment on your dream home).

In the EarlyRetirementExtreme.com blog, the author suggests spending no more than $300/person on housing. He personally does that by paying for ½ of the cost of an RV that he shares with his wife (she pays the other half). Although I used to spend $275 on rent by living in a living room during law school, my current salary allows me to rent a room in a 3-BR apartment for about $575, plus 1/3 of utilities, and still keep within a budget that lets me save 75% of my income. That’s obviously more than $300 per month, but it’s a great deal to live in a luxury high-rise in a really nice part of San Diego, and I don’t have to tell people I live in a living room.  The key is to find your own happy medium between what you can afford to pay and what you need to save.

Live Alone or Share?

If you’re married or living with a significant other, you’re already benefiting from the economies of shared living. If you’re single, having roommates is one of the best ways to save money, especially for young people who were often used to having roommates in college. I’ve kept my living expenses low by living with roommates my entire life (most of whom I didn’t know before I lived with them), and never regretted it. The problem is that you often find great places to live with less desirable roommates, or vice versa. If you don’t know anyone you want to live with, I suggest getting a 2 or 3 bedroom place by yourself, and then advertising for potential roommates on Craig’s list. Assuming you don’t come across like a serial killer, this will put you in a much better position to pick people you actually want to live with. Don’t forget to make sure they can actually pay the rent by checking their income and/or credit report.

But sharing your home isn’t just for young, single people either. In fact, one of our other planners is an empty nester who has taken on boarders for additional income. (Graduate students can be particularly good tenants.) A syndicated personal finance columnist has also written about how low-income retirees can benefit by living with a “family” of other retirees to save money.

Of course, these aren’t the only ways to save money on housing. If you have other ideas that you’ve heard of, or have tips from your own experience, please share them in the comments below!