Knowing what you can afford

Part of the idea behind this site is that many more people could afford to prefer not to—to opt out of the wealth-and-power competition of modern American life and thus gain a real measure of freedom—if only they were willing to give up some of the status games of conventional living. But to make that preferring-not-to choice, you’ve got to know what you have. Knowing what you have has a philosophical component (more about that in a later post) but it also has a brass-tacks, financial-knowledged component: In a very literal sense, can you afford the freedom that comes from preferring not to?

Here is some info and to help answer that question:

The cost of a good life

The first order of business is to figure out what it really takes to live a decent life. Of course, some people are really struggling—maybe you’re one of them. But our culture makes it all too easy to feel like you’re “just getting by” when you’re actually very well off by any objective set of criteria.

Here’s a good reality check: a calculator of where your income falls on the US household income. $80,000 is top third, $100,000 is the top quarter despite what some people seem to think. If you enjoy feeling guilty and/or rich, you can take a look at the global version, which shows that $32,500 is enough to put you in the global top 1%.

Of course, relative comparisons only go so far—having more money than someone else won’t keep you warm at night. So lets look in more detail at one of the issues that people frequently conclude they cannot afford—at least not unless they give up all hope of preferring not to and instead dedicate themselves to the conventional pursuit of wealth and status.

Houses

Here’s a ridiculously complicated calculator that lets you play around with all the factors that go into how much a house actually costs. That calculator may be a bit overwhelming, and it probably has far more dials to turn than you really need. But if you like overthinking things as much as I do, it’s a great way to get a feel for what goes into determining the real, month-to-month cost of a house.

If you’re less interested in playing around with all the variables, Google’s mortgage calculator is a much simpler route to a similar bottom line.

Real estate obviously varies a lot by location, but it does not vary nearly as much as you might think by state. Indeed, you can get a reasonable house for $100,000 in all 50 states. Conversely, you can spend a fortune on housing in just about any state if you really want to.

Instead of varying based on state or region of the county, home prices instead are very local. Here’s a map that gives a sense of just how local the variation really is. What this means is that you can live in whatever region of the country you want—and be within distance of family and everything—so long as you don’t insist on living right in the urban core (which, of course, becomes much easier when you’re preferring not to!)

And if you’re interested in pricing out specific neighborhoods, Zillow is a good place to start. No matter how close to the urban core you get, million-dollar homes are not at all a minimum—no, not even in the Bay Area.

But even if you can eventually move to a lower cost of living zip code, another issue that people face is knowing whether they can save in the near term. After all, getting to the position of saying “I’d prefer not to” can take hard work and saving.

Before we can get to savings, though, you need to have a good sense of how much money you’re actually getting to keep.

Income & taxes

When you’re thinking about future jobs, it’s also important to have a good sense of what the tax consequences would be. I don’t have a great tax calculator to recommend based on personal experience, since I estimate my taxes in an excel spreadsheet,[FN: More for the learning experience of seeing how all the rates/taxes come together than because I thought it would be better than an online tool.] but this tax calculator seems pretty good from a quick look. Despite some political rhetoric, total taxes are not as high as one might think. At most reasonable income ranges, your total average tax burden (federal income+payroll taxes+state taxes) is likely to be between 35–40%. Marginal tax rates can be much higher, of course (and, consequently, the difference between two salaries might be much less than it first appears).

Taxes on savings are another matter entirely: The bottom line is that you don’t need to pay much in taxes on savings, so they can grow even faster.

To begin with, most of your long-term savings should happen in tax-advantaged accounts. For retirement, an IRA or 401k is probably your best bet. An IRA is a tax-advantaged account that is totally under your control; you can fund it with pre-tax money (up to an annual limit), invest it however you like, and it grows tax free. You only pay tax when you withdraw the money in retirement. The only downside is that it has penalties if you take money out early—though you can take $20,000 to use as part of a down payment on a house. Here’s a more detailed description of IRAs for the currious. A 401k is like an IRA but offered through an employer and usually with fewer options about how to invest.

When saving for education, you have a choice between the well-named Education Savings Account and a 529. These offer similar tax advantages to retirement accounts, but are geared towards saving for your kids’ college.

Finally, if you do have significant savings outside a tax-advantaged account, remember that capital gains (the profits from increases in the price of stocks) are taxes at a lower rate than ordinary income. There are also automated ways to practice tax loss harvesting and reduce that even more. I can’t claim to have mastered that art—or, honestly, to have had the sort of assets that make it worthwhile—but I know it’s out there.

Once you have a good handle on how much you’re actually getting to keep (and, hopefully, are using a good budgeting system to make sure that your spending stays well below that level) it’s time to figure out just how far that savings will take you.

Savings

Now that you’re saving, you need to know how much that money will be worth when you need it. The first step is to find a good compound interest calculator. Even though Einstein probably didn’t call compound interest “the most powerful force in the universe,” it’s still really powerful. Plugging some numbers into a calculator will give you a much better sense of how much money you’re actually socking away in terms of how much that money will buy when you’re spending it.

Of course, the power of compound interest depends dramatically on what the interest rate is. Current bank savings rates aren’t much above 1%, which doesn’t help too much. On the other hand, for long-term savings, there’s no reason to stick with bank savings; it would be much better to invest in diversified stocks. One commonly cited rule of thumb is that stocks should return 10–12% before inflation (about 7–8% after inflation). Of course, we can do better than rules of thumb: Here’s a site that lets you see what the rate of return has been for any period since 1871.

If you are saving in the stock market for the long term, the best idea is to buy a broad, low cost index fund. The frugality and personal finace blogger Mister Money Mustache has a good post laying out the basics. (And if you’re put off by his informal style, more establishment advice will tell you the same thing.) The basic idea is to not try to beat the market but instead to avoid fees while tracking the market (aka the Efficient-market hypothesis.

Conclusion

After walking through all that, my guess is that many readers of this blog would find themselves much closer to I’d-prefer-not-to land than they thought they would be. I know that first figuring all this out was eye-opening for me. And the freedom that comes from rejecting the ridiculous status games is worth striving for.

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2 thoughts on “Knowing what you can afford”

  1. I’ve targeted FI/RE (Financial Independence / Retiring Early) for years, even before I knew there was a name for the concept. Spend well below your means, invest the difference, and eventually stop having to work for a living. My wife and I fall in that top quarter income, but most of our (outer) clothes come from thrift stores and hand-me-downs, our only car is old enough to vote, and we rent an apartment very close to work. Just as with politics, over the years we’ve learned never to discuss FI/RE with most friends and family. Though it’s still amusing to see them assume we’ve fallen on hard times when they find out about our thrift store shopping.

    There’s a fantastic book The Millionaire Next Door that paints a surprising picture of the typical US millionaire (in 1996): disproportionately middle-class and blue collar. Highly recommended. Also check out the FIRE subreddit: /r/financialindependence.

    Unfortunately there’s a massive roadblock for FIRE in the US: healthcare. It’s so costly and so closely tied to employment. My wife was diagnosed with multiple sclerosis a few years ago, and the treatment is utterly unaffordable without an employer healthcare plan. To put it in perspective, the wholesale cost of her treatment is more than half our income. Through my employer it costs us “nothing.” In order for us to retire early, she’d essentially have to give up treatment, and we’re not willing to opt out of that.

    1. I’m sorry to hear that about your wife. A serious illness is never easy, and it’s even harder when they also have financial implications. It’s definitely a risk I’ve thought of as well, though not one I’ve confronted (yet).

      Since you must have looked into it much more than I have, I have a question: Why isn’t medicaid or some state equivalent a good protection for your circumstance? I would have thought that, with your low spending, you could quit your job and have a low enough (taxable) income to qualify for those sorts of programs while still having an pleasent standard of living (and letting your assets grow in tax free accounts for the time when your wife qualifies for medicare). But my understanding of that is purely from Internet research–I’m sure I missed something.

      I second all your recommendations, especially for The Millionaire Next Door, though I do wish they’d write an updated edition.

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