Affordable is a tricky word. If you look at it simply enough, when an item is affordable then you can spare the money to buy it. But I’ve been thinking a lot about this lately. I’ve had discussions with various friends about this, largely stemming over the potential large purchases in life (cars, houses, engagement rings) or the month to month costs that we regularly incur (iPhones, iPhones, iPhones). What I’ve realized is that most people have very different beliefs over what affordable means and when certain things are affordable. So everyone is on the same page, I think we have to define the term for pretty much all purposes going forward.
Defining what is affordable and what is not has to be a fluid state. What’s affordable for someone making $20k a year will probably be significantly different than for someone that is making $100K a year. That can get even more skewed if the person making $20k a year is actually just collecting that in dividends from their $1Million in mutual funds. So let’s just try to set some base rules. We’re talking major purchases and everyday recurring transactions.
1. Homes: The rule of thumb that you will hear from bankers and mortgage brokers is that your monthly home payment shouldn’t be more than 30% of your gross income(income before taxes) for that month. There is actually a decent amount of debate here in the personal finance community, mostly because frugality is constantly desired. A modest home can achieve just as much love and happiness as an expensive home can, while saving you a huge chunk of cash. Let’s look at the numbers here if you’re on a budget with a $50k a year gross income. That means your take home gross is $4,166.67 a month, before taxes. This means that your home payment can be as high as $1,250 a month. That doesn’t sound bad until you realize that your take home, after tax income is only about $1,450 each pay period (semi-monthly pay). So on the first of every month you pay your mortgage and than have only $200 until your next paycheck to cover your expenses. In the interest of keeping our budgets in check and maximizing savings, I think that 20% is probably the actual best number for someone to pay for their home. Realistically, this should be for both a rental and for a home (yes, I know that with property tax deduction you can do more for a mortgage but hey, we’re trying to simplify!). Verdict: no more than 20% of gross income
2. Cars: This is a simple one. We’ve mentioned it in the past and I’ve stolen it straight from the Financial Samurai himself. Never purchase a car that costs more than 10% of your gross annual income. If you make $50K a year, then you better find a good and reliable $5K car to purchase. I know that I’m guilty of not following this rule myself but, in my defense, I hadn’t started trying to turn my financial world around at that point. And I wouldn’t do it again. The truth here is that by using a disciplined approach on this big purchase, you don’t have to suffer the opportunity cost of money lost on car payments when they could have been spent on investments. If you’re serious about getting your finances in shape, it’s essential to follow this rule. Verdict: no more than 10% of gross income
3. Cell Phones: Everyone has one. Everyone. And pretty much everyone out there has an iPhone or an amazing Android. However, the plans from the big providers can cost you well over $100. I don’t pay for my plan (company phone) but I know that the cost is somewhere around $125 a month. Now, it’s ok for my company to expense it but for me, that’s a steep price to pay. There are other, better plans, from some carriers out there that will run you less than $50 a month. T-Mobile offers some extremely competitive plans in this area with unlimited data. Another great plan is Republic Wireless. On their network you pay $19 a month, get a pretty good phone and end up with unlimited talking, data, and texting. You have to hook it up to your wifi network at home but I’d say it’s worth the cost. If I didn’t have a work phone, I’d probably go with this. Verdict: No need to ever spend more than $50 here
4. Discretionary items: A lot of every day items tend to be things that people think they can afford. I’m talking about clothing, a night out, or an expensive dinner. While I don’t think we should restrict ourselves completely (it’s ok to buy yourself something nice every once in a while), we all have to stick to our budgets and live within our means. If someone has a goal of saving 30% of their salary a month and has 30% tied up in their car and home payments, well, they only have 40% left to split up amongst utilities, gas, groceries, and taxes. Those items can take up to 30% of one’s income. That means that only 10% is left for the fun discretionary things. If you make 50K a year, you’re not going to have much more than that 10% to really spend on the extravagant things in life. Verdict: 10% of your income is discretionary, no more!
I know that some of these items seem fairly harsh but we all know that we spend too much money. Without sitting down and really quantifying what affordable truly means in dollars, we will never really know. Use these amounts as guidelines or maybe you have some of your own. I’m sure that there might be a category or two out there that I’ve missed!
Picture courtesy of Nobuyuki Hayashi