Although I’ve said that overpaying for a car is the #1 wealth killer for the middle class, paying ever rising rent over the long run could actually be way worse. Inflation is an unstoppable juggernaut that will smash your retirement dreams to smithereens if you aren’t on the right side.
There’s a general guideline that says renters shouldn’t spend more than 30% of their net income on rent. The 30% recommendation comes from the Brooke Amendment passed in 1969 which determined the point where a family living in public housing was considered financially burdened by housing costs.
As for homeowners, few banks will lend beyond a 43% debt-to-gross income ratio (10% too high IMO). For example, if you pay $2,000 a month for your mortgage and another $300 a month for an auto loan and $300 a month for student loans, your monthly debt payments are $2600. If your gross monthly income is $8,000, then your debt-to-income ratio is 33 percent.
In this article, I’d like to layout a housing expense framework to help folks reach financial independence sooner. I’ll go through my own housing expense history to reveal some nuggets of wisdom.
The FIRE Death Chart
First, let’s take a look at this interesting chart that shows the rent burden for younger residents in several major cities.
The influx of new people over the past two decades has far surpassed existing housing supply due to concentrated job growth in America’s major cities. As a result, rents and housing prices have skyrocketed. We’ve reached a breaking point, which is why I’m actively investing in the heartland of America instead for the next decade.
I’ve never worked in Los Angeles, the most rent burdened city surprisingly, but I did start my career in NYC in 1999 and finished my career in San Francisco in 2012. Here’s a timeline of my housing expense history.
NYC 1999 – 2000: NYC felt just as expensive then as it does now. To cut costs and reduce commute time, I decided to share a studio at 45 Wall Street with a buddy of mine from high school. The place was just a eight minute walk to work at 1 New York Plaza. We paid $800 each for the luxury of passing out each night after a 14-hour work day.
My base salary was $40,000 a year or $3,333 a month plus an unknown bonus. Therefore, my rental expense made up 24% of my gross income. My fellow analysts at Goldman Sachs either rented a one bedroom for $1,800+/month or had their parents buy them their own place. There was a ton of Bank of Mom and Dad going around.
I could have joined my colleagues in spending ~50% of my gross income on rent, but I made a conscious decision to save more money because I was maxing out my 401k from the get go. Walking to work in the dark and walking back home in the dark was depressing. I had to save aggressively in order to one day be free!
NYC 2000 – 2001: My first roommate moved out because his parents bought him a one bedroom condo on the upper east side for $250,000 that lucky duck. It was a great buy since it’s worth ~$750,000 today. Even though his parents helped him out, 17 years later, he still lives in his one bedroom condo with his wife! Talk about living luxuriously and frugally at the same time.
The Street decided to bump up all first year starting analyst salaries to $50,000 from $40,000 in 2000. As a result, my salary went from $40,000 to $55,000 given I was now second turd on the rung. I found a new roommate and rented a studio with an alcove for $1,800 a month. Now we were living large!
I lived in the living room and he lived in the windowless room for $900 a piece. With a new gross monthly salary of $4,583, I was now paying just 19.6% of my salary in rent. Again, I could have very easily decided to get my own one bedroom apartment for $2,000 a month, but work continued to be too painful. Including my bonus, my income was over $100,000.
SF 2001 – 2002: The biggest surprise about moving to San Francisco was how much cheaper rent was compared to Manhattan. Still frugal, despite a raise and a promotion, I decided to rent a room in a two bedroom, one bathroom apartment at the edge of Chinatown for $900 a month. Going from living in a living room with no privacy to having my own room and shared common space felt like a luxury! But I knew the place was a dump (see picture).
I joined my new firm as an Associate with a new salary of $80,000. My rent as a percentage of gross income fell to just 13.5%. A couple colleagues made fun of me for not living in a more posh neighborhood. But it just felt stupid to spend up when I didn’t know for sure I’d be in SF long term. I was still exploring a new city and wanted to keep living costs to a minimum. Finally, I was starting to feel rich living so modestly. What a contradiction.
SF 2002 – 2003: My roommate turned out to be a little unstable, randomly screaming his lungs out in the middle of the night. After my girlfriend stayed with me for several months in this 2/1 apartment at the edge of Chinatown, we decided to get our own one bedroom apartment in Cow Hollow, a nicer neighborhood in SF’s north side for $1,600 a month.
I paid $1,000 a month and she paid $600 a month given she was only one year into her career. My salary was now $90,000 (tends to go up $10,000 a year in finance back then), meaning that I was paying 13.3% of my gross salary to rent. However, if you account for my bonus, which can range from 50% – 200% of salary, my rent made up less than 10% of my annual gross salary.
Once I got rent down to under 10% of my annual gross salary, I started feeling like I was making massive financial progress. Rent no longer felt like a burden, even after maxing out my 401k, investing ~30% of my post 401k cash flow every month, and investing 100% of my bonus.
Oh, and the one bedroom was also kind of a dump. It was very dark and right below an alcoholic neighbor who would leave deep bass music on all night long. Drove us nuts! Every week the blue recycle bin was full of beer cans.
SF 2003 – 2005: With a good amount of cash flow at 25, I started wondering what was the point of working so hard since I was living much lower than my means compared to my peers (quarter life crisis). When you start feeling rich, you want to improve your life! At the same time, I didn’t want to pay more than $2,000 a month in rent, which was what was required to get a nicer place.
Instead of renting, I decided to buy a 2/2 condo for $580,500 with 25% down and assume a $2,100 mortgage + $230/month HOA + $500/month property tax instead. Although the total came out to $2,830 in cash outflow, the net cost after deductions was more like $1,900 a month. With a new monthly base salary of $8,333, my housing expense grew to 34% before deductions and 23% after deductions.
The $435,000 mortgage lit a fire under my ass to work harder. I never felt this much financial burden in my life. It was stressful knowing that if I lost my job, I may lose my condo. I’m not sure if I would have continued working in finance after age 26 if it wasn’t for debt.
For the next 12 years, the monthly mortgage kept going down with each refinance until I paid the sucker off in 2015. Meanwhile, the median rent for a 2/2 apartment in SF went from $2,100 to $4,600! How nuts is that? The property is currently a $4,200/month rental. I’m below the median, despite the prime location because it’s not remodeled.
While the average renter was getting crushed by inflation, the average homeowner saw his housing payments go down because of a 30+ year trend in declining mortgage rates. See the mortgage rate chart below for evidence. When I first bought my condo, my mortgage rate was 5.25% compared to 3.375% for my last refinance = 36% decline. It’s always worth checking the latest rates to refinance.
2005 – 2014: After a couple of years in the condo, I actually regretted not buying a nicer place in 2003 because property prices continued to grow (greed). As a result, I took on a whopping $1,220,000 mortgage at 28 and bought a $1,520,000 single family house at the end of 2004 that ended up being two bedrooms too large for my eventual wife and me. I let the sellers rent back the place for 3.5 months before we moved in 2005.
My housing expense as a percentage of gross income got as high as 60%! Once again, I was worried about my future. It also felt wasteful to own a four bedroom, three and a half bathroom house with just the two of us. As a result, I rented out the garden room to help defray expenses. My housing expense eventually fell to 28% of my base salary after earning some raises over the next nine years. If you include my bonus, the lowest my housing expense got was ~8.3% of gross income.
2014 – Now: When I first bought my current primary residence in 2014, my gross housing expense was ~24% of my gross income, or 17% of my gross income after deductions. I purposefully bought an 18% cheaper house than my previous residence because I was earning less and wanted a smaller house. I was able to lock in a 2.5% 5/1 ARM.
Due to further income growth, my housing expense today is ~8.2% of my gross income before deductions and ~5.7% of my gross income after deductions. I’m now wondering whether I’m living too frugally again. The idea of buying that dream house in Honolulu one block from the beach in 2020 can’t come soon enough!
Keep Housing Costs Under 10% Of Gross Income
Although the general rule is to keep housing expenses to no more than 30% of your gross income, you will NOT feel like you’re getting ahead at 30%. Instead, you’ll feel like you’re running in place. Heaven forbid you’re one of the ~22 million Americans who are spending more! Only after I got my housing costs to below 10% of my gross income did I start making massive financial progress.
For those of you who live in expensive cities, you might think that spending less than 30% is next to impossible. But that’s exactly what some people are doing by sharing a bedroom, sharing a studio, living with five roommates, or even living in a van like one Google employee is doing. Decide on a housing expense limit and adjust accordingly, not the other way around.
When you’re in your 20s, who cares about living in a nice place? I was making over $100,000 and living in a living room! My guests didn’t mind. If you’re chilling at home, you’re not at work, which is exactly where you should be most of the time. If you’re bullish about your career, only then should you consider buying a property and spending ~30% of your gross income on housing.
Aggressively saving money on housing for 10 years will pay off. Keeping your housing expense to <10% means you can easily save and invest 50%+ of your income each month. Eventually, you may want to live in a nicer place if you find a partner or start a family. But from ages 18 – 34, living like a pauper is great for financial independence seekers!
Explore real estate crowdfunding: If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today. They allow everyone to invest in mid-market commercial real estate deals across the country that were once only available to institutions or super high net worth individuals. They are the pioneers of eREIT funds and they are creating an Opportunity Fund to take advantage of tax-efficient Opportunity Zones. Thanks to technology, it’s now much easier to take advantage of lower valuation, higher net rental yield properties across America.
Shop around for a mortgage: Mortgage rates are coming back down after the initial ramp post Trump’s victory. Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a new 2.625% 1/1 ARM for my latest refinance in 4Q2019. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Updated for 2020 and beyond.