Why Housing Costs Shouldn't Exceed 30% of Your Budget

Author: Daniel Harris

Housing is definitely the biggest expense we face in our lives. Whether you're a homeowner or renter, having a warm, safe place to live is a number one priority, and our budgets should reflect that. Sometimes, though, people get a bit carried away and spend their money on things they don't need, including buying a house that is too big. (For more, see For Financial Independence, Forget the McMansion.)

Therefore, the idea of limiting housing costs to a third of your budget seems contradictory. If housing is the most important part of our life, why aren't we dedicating more money to it? Financial experts will argue that there's no problem with allocating 50% of your net income to housing, but that barely leaves enough money for living comfortably. Reducing housing expenses to 30% of one's monthly income allows people to live much more balanced lives.

Increased Cash Flow

It's safe to assume that no one wants to sit at home during all their free time. People are social creatures, and we want to get out and meet up with people and have coffee and go hiking. Even if you only socialize at home and hate interacting with people, you'll still need to find something to occupy your time, and hobbies are expensive! (For more, see Five Expensive Hobbies.)

In a perfect world, an ideal budget would look like this:

Housing: 30%

Transportation: 15%

Savings: 10%

Debt: 15%

Miscellaneous life expenses: 30%

Increasing cash flow should be a major goal for anyone looking to retire early or to get rich. One way to increase cash flow is to increase income, but if you, like many Americans, are too busy to do so, you can cut expenses instead. Cutting housing costs is one of the most effective ways to increase cash flow in a budget, along with cutting your transportation budget or paying off debt. (For more, see When Paying Down Debt Doesn't Make Sense.)

By spending only 30% of your budget on housing, the remaining 70% is freed up for so many other things. With this much cash flow, a person starts to notice a lot more flexibility in their budget. Imagine not having debt or a car and easily being able to save 40% of your income? Or imagine foregoing savings, a car and some life expenses to put 60% of your net income onto your credit card? What about being able to pay for an emergency just by reducing your grocery expenses and not saving money one month? These are realities when you reduce your housing costs and free up cash flow.

Smaller House = Closer Family

McMansions or not, the size of houses is incredible these days. It boggles the mind that people will buy houses with bedrooms that exceed the number of occupants or that parents will insist on buying a house that their family can grow into. Children can share a room, families can share a bathroom and cars can be parked outside. Life experiences and sending your kids to good schools should be priorities, not spending half your income so that each occupant can have a private bathroom. (For more, see Five Mistakes To Avoid When Buying A New Home.)

A real benefit to spending less money on a smaller house is that the size will literally bring your family closer together. In a world where even children have their own smartphones and face-to-face communication is dwindling, family time is falling by the wayside. By forcing everyone to eat dinner in the same room or to watch TV on the same screen, we're able to accomplish two things at once: connecting with other people and inexpensively entertaining ourselves.

Diversified Portfolio

Like increasing cash flow, diversification is key to amassing wealth and preparing for early retirement. Why then, do people spend so much money on their home? With the average homeowner only living in his or her house for nine years, the idea of a family home to which the kids will return during college vacation is dead. While renting is an obvious choice for people who like to move or keep flexibility in their lives, those looking to buy their own home should buy only what they need in that moment of their lives. (For more, see To Rent Or Buy: There's More To It Than Money.)

For a young family with a baby, a one- or two-bedroom house will suffice. For a family of two children, a two-bedroom house is a must. Once the kids are old enough, a one-bedroom house with a finished basement is perfect for teenagers looking for privacy and parents hoping for quiet on the ground floor. Once the nest is empty, it's time to sell and look into condominiums that don't require yard work or as many household repairs.

Moving constantly and adapting to life is quite similar to readjusting a portfolio every year. It would be unwise to buy stocks, bonds and ETFs and then forget about them for years even though you know the allocation isn't right. However, people constantly do this with their biggest asset – their house – without even considering that they should change their housing situation on a regular basis. While moving every year is wholly undesirable, especially for families, moving every three to five years should be feasible enough to keep up with the changing demands of your life.

The Bottom Line

By placing more than 30% of your income into the housing category, your asset allocations become skewed and irresponsible. A person with $20,000 in credit card debt shouldn't be spending 15% of his income on debt repayment, he should be spending 50%. A recent college graduate shouldn't only save 10% of her paycheck; she should continue living like a student and save 40% or more.

By increasing savings, decreasing debt and spending no more than 30% of your income on housing, you can funnel a lot of money towards hobbies, personal projects or plain old investment accounts. Ask 100 people on the street and most would choose a large, well-diversified portfolio over an extra bedroom.