Introduction

In this second and last commentary on the relation between expenses and savings, we look at the particular case of spending on housing and food; for the first commentary, see The image monster and your savings rate .

We gave some figures on the relative importance of income taxes and the various other categories of personal expenses in our first commentary. We have since found a text or as a PDF doc.1630 from StatsCan which explains how they change depending on your income level:

The  table shows that total expenditures on housing and food is important for all income categories, but its relative importance decreases by almost half from the lower to upper income categories.. Which other expenses takes over? The table shows that the relative importance of income taxes increases dramatically with the level of your income. These figures confirm the importance of seeking by all legal means (e.g., opening a RRSP and TFSA) to minimize the amount of income tax that you pay; see our previous commentary on sources of tax information.

The importance of saving rather than spending

We all understand intuitively that saving today enables you to spend more tomorrow, and the opposite (an expense today will hurt your savings tomorrow).

But numbers often drive home a point even more. To quantify how much better off we will eventually be by deferring a dollar of spending today, we must estimate the future level of inflation and the performance of your portfolio into which you funnel your savings. Let’s do the exercise.

The following sites discuss how much you can expect to earn in the long term on your investments in equities (and bonds in the case of Schwab):

TaxTips
DailySpeculations
InvestorsFriend
Schwab
ProtectYourNestEggInRetirement

The long-term performance of your portfolio depends primarily on your Asset Allocation; see Asset allocation on our site. Often the bond portion will barely succeed in beating inflation. For a neutral portfolio (60% equities 40% bonds) we will assume for discussion purposes a long-term performance before inflation of 6%. In 24 years, such a performance means that $100 would increase to about $400. Moreover, inflation during the period 1986-2010 (using a US calculator) was such that $200 in1986 was worth about $100 in 2010. Assuming the same rate of inflation and the above-assumed investment return for the next 24 years, the result is that a dollar saved today and invested should allow you to double your spending in constant dollars 24 years later. And if your performance or presumed period of savings increases, the scenario will be even better.

Let's now look at two specific expenses, housing and food.

Housing

Long Term Trends

Many people believe that their residence is not just a place to live, but also an investment. We will not revisit here this issue, but to know why we believe you should not consider your house as an investment, see

The family residence ;
The Investor's Manifesto by William J. Bernstein: a  book review
How that other market is doing: residential real estate

But rightly or wrongly most Canadians believe that their residence is an investment rather than an expense, and they feel justified to open their wallet wide open and buy a bigger, better and more expensive house. What has been the outcome?

For the past century, there has been an inverse relationship between size of families and of houses; the first is declining, while the second is growing. Here are some U.S. sources, but the situation is similar in Canada:

Size of houses:

At the beginning of the last century, the average home was 700 to 1,200 square feet. In 1950 the average home was 1,000 square feet growing to an average size of 2,000 square feet in 2000.
Source: Moyak.com

Size of family units:

Average household size declined from 4.60 in 1900 to 2.59 in 2000, or by 44 percent.
Source: study by Hobbs & Stoops Demographic Trends 2002 or as a  PDF doc.1632 based on US census data, p.137 

And the result?

We've gone from having no bedrooms to: In the recent past the middle-class bedroom has become an ever more private place. With its own attached bathroom, telephone, and TV set, the 'main suite' has assumed something of the character of a self-contained apartment. Walled up in their flat within a home, middle-class parents have built an unprecedented barrier between themselves and their offspring. It should come as little surprise, then, that their kids have responded in kind. Since the 60s the number of larger homes has grown while the average number of household residents has shrunk - quite dramatically in fact. One result has been that young children now commonly have a bedroom each, while most adolescents regard this condition as an entitlement, not a privilege. The rooms themselves offer a separate place for schoolwork, and often include radios, televisions, and phones among the many electronic gadgets once available only centrally within the house. Source: Moyak.com

It is not our website that will stop these trends, but we do encourage our readers to review whether the size and cost of their house occupies a disproportionate place in their lives and has become a barrier to their ability to save.

Now let’s look at a few housing rules of thumb.

The house- is the price it too high?

Is the current market is overheated? What criteria should we use to decide if the price of a home is too high? Here's one rule of thumb that may help you know if a price is too high (but it will not help you decide whether you would be better to buy a house cheaper and save more by taking what you have saved and  investing it).

According to his 150 / 1 rule Bernstein says you should never pay more than 150 times what you would pay in monthly rent for an equivalent house; see The Investor's Manifesto by William J. Bernstein: a book review .

The CMHC home ownership rule of thumb

Almost all housing rules of thumb are designed to tell you if you have the financial capacity to pay a certain price for a house. They will not help you determine if the price of a particular house is too high, nor if you would be better off to buy a cheaper house and take what you are not saving on your housing bill and investing it.

We begin with the Canadian Central Mortgage and Housing corporation (CMHC) before looking at some non-governmental sources:

According to CMHC or as a PDF doc.1633, housing expenses should not exceed 32% of gross income, and the monthly debt payments should not exceed 40%:

Mortgage Affordability Calculator — How Much Can You Afford?
The shortest answer to that question is: it depends on a number of factors. The most important are your gross household income, your down payment and the mortgage interest rate. Lenders will also consider your assets and liabilities. Your own lifestyle and debt comfort zone also come into play.
Use the Mortgage Affordability Calculator to estimate the maximum mortgage you can afford
This calculation is based on two simple rules that lenders use to determine how much of a mortgage you can afford. The first rule is that your monthly housing costs should not exceed 32% of your gross monthly household income. Housing costs include monthly mortgage payments, taxes and heating expenses. If applicable, this sum should also include half of monthly condominium fees.
Secondly, your entire monthly debt load should not be any more than 40% of your gross monthly income. This includes housing costs, and other debts such as car payments, personal loans, and credit card payments.

Other rules of thumb

Now here are some other examples of rules of thumb that use different ways to calculate how much you can afford to pay or borrow. We stress again that these rules will not tell you if it is wise to buy a house in a particular price range, but only if you have the financial resources to write the check.

1-A limit based on your income

Under this rule, do not pay more than a certain multiple of your income:

How much house can I buy? If you're buying a home and don't want to feel stretched over hot coals for years to come, the home shouldn't cost more than two-and-a-half times your gross income. Source: CNN Money or as a PDF doc.1634

2 - Limit based on the mortgage

Others recommend that the principal amount of the mortgage you take out to buy your house not exceed a certain multiple of your income:

How much house can you afford? @FrugalTrader writes, “When getting a new mortgage, the balance should be less than 2x your family annual income.” So, if your family makes $120,000 per year, your mortgage should be $240,000 or less. Source: GetRichSlowly or as a PDF doc.1279.

 3 – Expense/income ratios

Other rules of thumb are similar to the approach of CMHC. They compare the total expenses related to your home (mortgage interest, taxes, heating etc.)  to your income.

First, you need to know what your income and current expenses
are. The Canadian government recommends that your mortgage
payment should not exceed 30% of your income. Keep in mind
that your mortgage payment is not going to be your only additional
expense when buying a home. Source: ConsolidatedCredit.ca or as a  PDF doc.1636

When lenders calculate how much house a borrower can afford, they use the debt-to-income ratio, a measure of how much of your income goes toward debt. These lending limits have crept upward with time. I’m a strong advocate of being conservative here. I believe your housing costs should be less than 28% of your gross income, and your total monthly debt payments should be less than 36%. These numbers provide ample room but prevent borrowers from being trapped by too much debt. Source: GetRichSlowly       

3.5 – This is roughly the amount of house you can afford on your gross annual income. If you make $100,000 per year, the most house you can afford is ideally $350,000 assuming a 20% down payment and a mortgage of $280,000 over 25 years. With a mortgage at 7%, the monthly payments would be $2,000 a month. Once you add utilities, property tax and insurance your using roughly 30% of your gross income (see 32% below).
32% –   This is the percentage of your gross income you can afford for a home. One-third of your pre-tax income is devoted to paying your rent or mortgage, property tax, house insurance and utilities. Any more than that and you are in danger.
Source: Blog.taxresource.ca or as a PDF doc.1637

Keep your mortgage or rent payment to no more than 30% of your gross  income.While you can obtain a mortgage for more than that, staying within this rule will help ensure you have money to devote to other financial goals. Source: Rules of thumb from InvestorGuide

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