Many people believe a pay raise is the answer to their questions when it comes to increasing your wealth.
But in reality, reducing your spending is often a better alternative.
No, I am not talking about budgeting the small stuff, like stop drinking coffee or going out for drinks on the weekend. I am talking about the big expenses that we must pay to survive.
What are these expenses? Well, I want to focus on one, in particular, your housing expense.
Arguably the largest expense each month for the average American is housing or rent. Whether you own a house or rent your monthly living costs make up a good chunk of your budget.
According to the Bureau of Labor and Statistics, the average housing costs is roughly 33% of the total monthly spending followed by transportation at 17%.
Combined that’s 50% of one’s total budget, which is absolutely insane!!!
Note: This post is for educational purposes only, please speak with a financial advisor for any financial advice! Read full disclosure policy.
I’ll say it again; many people believe a pay raise is an answer to their questions when it comes to money. However, let me try and convince you otherwise.
If you’re able to get a substantial pay increase of at least 35-40% then yes, I would agree that a pay raise could be the solution to your problem. However, I would also argue that with an increase in pay, comes an increase in spending, potentially more stress, and a father commute.
If you’re in Corporate America or a mid-sized company, then it is very unlikely to get a pay increase of 35-40%. Maybe towards the end of one’s career, but the goal of this blog is early financial freedom and not relying on a 30-year career.
In corporate America, your salary is based on tenure with little wiggle room depending on performance. You are capped at a specific pay increase each year, no matter how much you deliver. Usually, depending on the company you can receive a merit increase from 1-3% each year and if you get a promotion can expect anywhere from a 3-10% salary increase.
However, if you are fortunate enough to get a pay raise, the increased income is subject to tax! So, in theory, you only get a percentage of that increase, not the full amount!
On the other hand, if you are able to reduce your expenses, you get an immediate after-tax increase in wealth at 100% of the saved amount. Let’s take a look at an example.
Nancy works in corporate America and has a nice salary of $50,000 per year. If you break her income down by pay-period which is bi-weekly, her pre-tax income is:
Assuming Nancy pays her taxes and is in the 25% tax bracket, her after-tax income is
She likes her job, it isn’t stressful and likes her guaranteed income each month. However, she currently rents a nice 1 bedroom apartment for $1,500 in the nicest part of town. So, over the course of the year, Nancy pays $18,000 in total in rent.
Nancy loves her nice apartment but after a few months isn’t able to save as much as she’s used too because her rent is so high. This is because 36% of her income ($18,000/$50,000 = 36%) goes toward just her rent alone (not including utilities).
If you calculate this looking at after-tax income, 48% ($18,000/$37,500 = 48%) of her income goes to rent! Crazy!
Nancy thought increasing her income would be the answer to her problems, and saw an ad for a job listing that could increase her salary by $10,000. However, the job requires a further commute of 15 minutes each way and demands more time and effort from her current job, requiring her to potentially work longer hours.
Let’s pretend Nancy took the job and now makes $60,000 a year or $2,307 pre-tax every two weeks. Post-tax (after taxes are taking out of her paycheck Nancy brings home $45,000 or $1,730 every two weeks. After taxes, she increases her income by $7,500 however increased her expenses due to a further commute.
Nancy isn’t thrilled with her new job, due to the increased stress and longer commute. When she accepted the job, she thought she could save more money each pay period ($280 to be exact), but failed to realize the extra cost of her commute making her not save as much as she thought.
By getting the new job, Nancy now increased her income by only $7,500 after tax. However, she also increased her commute by 15 minutes each way which is taking her time and money. Also, She is required to stay longer at the office because of the heavy workload at her new job.
In theory, I would argue, the overall benefit is less than $7,500 due to the additional commute and time away from her personal life. For conservative numbers, let’s say that an additional 15-minute commute each way is $500 for the year, so her overall increase in wealth after taxes with a longer commute is only $7,000.
Instead of deciding to get a new job, let’s pretend the following happened.
Nancy woke up with the realization that she didn’t want to live paycheck to paycheck for the next 30 years until retirement. She doesn’t want to rely solely on her 401k as her only retirement fund and wants to find another solution. In fact, she wants to find financial freedom and maybe retire earlier than the traditional retirement age of 65.
Instead of applying for that new job which can increase her salary from $50,000 to $60,000 she looks alternative sources of income.
She realized in order to gain financial freedom, she will have to start building her wealth with an additional method other than her salary.
Nancy notices she spends $18,000 a year for her 1 bedroom apartment and her lease is ending next month.
A great tool to monitor your money and track your expenses is www.mint.com.
She currently isn’t able to save much money for investment because most of her paycheck is going to her rent. Knowing how important it is to save money, she decides to reduce her living expenses.
After doing the math, she realized if she got the job which paid $60,000 a year, it would increase her wealth by $7,000 after taxes and commuting costs.
Instead, if she could reduce her housing expenses by $7,000 she would be able to keep her current job which allows her to spend more time at home doing the things she loves.
Let’s take a look at some options Nancy could take to reduce her living costs.
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The most obvious method to reduce one’s living expenses (especially for renters) is splitting it 50-50 with a roommate. I realize this may not be possible for some, especially those who have a family with children. But there are alternative options for you discussed further below.
However, in Nancy’s case, finding a roommate and moving into a 2-bedroom apartment could be a quick win and an easy solution for her to start saving money.
Let’s say she found a little older 2-bedroom apartment that’s $1,600 a month that she can split with a roommate. Her housing cost is now only $800 per month or $9,600 for the year, instead of $1500 per month or $18,000.
This effectively increases her wealth by $8,400 while keeping the same job ($18,000 yearly rent – $9,600 her new yearly rent with a roommate = $8,400).
She can allocate that saved $8,400 into a high-interest savings account with the goal to purchase an investment or allocate the savings to an investment account like, Acorns, online investment brokerage that has the potential to earn a greater return.
Compare this scenario to the example above where Nancy kept the same job but increased her salary from $50,000 to $60,000.
Nancy’s actually losing $1,400 ($8,400 – $7,000 = $1,400) if she decided to stay in her 1 bedroom apartment and take the new job. This doesn’t even account for the more stress and loss of her personal time from the new job.
She is able to keep $1,400 more dollars by reducing her living expenses.
Reminder – the goal hear is financial freedom, I understand that some people rather have their own place, but if the goal is to become financially free, sacrifice a little now so you can save faster!
An alternative method to finding a roommate and renting is buying a property, let’s look at a few examples where Nancy can reduce her living expense by buying a property.
If Nancy already has a good amount of savings stashed away, then she should consider purchasing a property. However not just any property, one with an investment in mind!
Wait a minute…
“Becoming a homeowner is a good investment, right?” Not always…
Sometimes single family homes are more of a liability than an asset and you want to have an investor’s mindset when looking for properties.
When you’re able to buy a property you are often maxed at what you qualify for based on your income. Finding a property that maxes what you’re qualified for, like buying the most luxurious single family home you can possibly afford is setting yourself up for financial purgatory.
Why? Well, let’s look at the typical scenario of someone with a $50,000 salary looking to purchase a home. Continuing with Nancy as the example, she makes $50,000 per year.
Her current rent at $1,500 for her 1 bedroom apartment and wants to reduce her monthly expenses, so she decides to stop renting and buy a home
Since she earns $50,000 a year, she qualifies for a loan up to $200,000, however that would be stretching her budget significantly.
If Nancy bought the $200,000 property she is entering financial purgatory because a big chunk of her hard earned money is going into the house, mortgage, interest, taxes and insurance (totaling $1,600, $100 more than her current rent), instead of her savings. You could argue that the more expensive the house the better the appreciation, but that’s speculation which we don’t want to rely on!
Also, some make the case that due to how hard they work to earn their money that they deserve to spend it and that’s completely fine. However, understand those actions will not get you closer to financial freedom, rather slow you down significantly.
Jumping back to Nancy…
Nancy realizes she doesn’t want to go into financial purgatory and max out her budget so she looks for a cheaper house!
She finds a 3 bedroom 1 bath house for $150,000, in an area that is nice and close to her job. With a 5% down payment as an owner-occupied buyer, she can put down $7,500 and expect a monthly mortgage payment around $1,100-1,200 after taxes and insurance. This effectively reduces her rent from $1,500 to $1,200 and saves her $300 per month or $3,600 per year. She is also building equity in her home each month when she makes her mortgage payment.
For the purpose of this post, we will ignore the following arguments for simplicity.
Buying a single family home that doesn’t max out Nancy’s budget is slightly better renting alone paying $1,500. However, I would make the case it is better for her to have a roommate and reduce her living costs to $800 a month rather than buying this property.
Well, I assume she will use the money saved each month wisely. Hopefully, saving it for future investments or actively investing the savings immediately. Unless of course, she plans to bring in a roommate and essentially house hack the single-family home (more on this later). By adding a roommate she has the ability to rent a room out for $600-$800 dropping her living expenses down to $600-$400 a month, a huge savings.
A better alternative to buying a move in ready single family home is buying a house in need of some repairs. What do I mean by repairs?
I am not talking about Chip and Joanne where you take a super distressed house and strip it down to the foundation, flip it and sell it for a massive profit (however you certainly can do that). I am more talking about a home with good bones, but isn’t cosmetically pleasing.
If you purchase a home that’s undervalued in need of a little TLC you can increase the value of the property with easy renovations.
The only problem with this strategy is that it’s harder to finance a property that needs some repairs. Banks don’t like construction projects, banks like livable homes. So if the home is livable, just outdated then you’re in luck when it comes to financing.
Ok, back to the scenarios…
Let’s say Nancy finds a property that has good bones and a lot of potential with not too much renovation needed. The property is a 3 bed 1 bath home that is selling for $70,000 in a neighborhood where the average value is $125,000-$140,000.
An upgraded kitchen with new cabinets and countertops and an upgraded bathroom could do the trick to greatly increase the home’s value.
However, since this property is livable (just outdated) foreclosed she is able to find a loan. Let’s also say Nancy had a roommate the last two years and was able to save up a nice stash of cash to set aside for renovations!
Nancy could purchase the property with a low money down loan through FHA or conventional (I would recommend a conventional loan) and invest roughly $20,000 into the property through renovations. If she wanted to say money, she could do the work herself with friends and family to save money.
After purchasing the outdated property for $70,000 and investing an additional $20,000 in renovations, Nancy’s new home is now worth $125,000. By doing this Nancy just created $35,000 of equity in her home by increasing the value of the property.
$125,000 purchase price – $20,000 rennovations – $70,000 purchase price = $35,000 increased equity
Let’s compare this to her original renting scenario.
On a mortgage of a $70,000 property with a 5% down conventional loan, you can expect mortgage costs to be anywhere from $400-$550 per month including interests, taxes, and insurance.
So Nancy would drop her monthly expenses from $1,500 in rent to $400-$550 towards her property each month. Yes, she needs to renovate it which requires capital, however, she will save a significant amount of money over time.
From reducing her monthly costs, from $1,500 to $450-$550 she effectively saves $1,000 a month or $12,000 that could help fund her renovations!
After the renovations are complete and the house gets appraised for $125,000, Nancy increased her wealth by $35,000 (calculation explained above).
Now for all of the naysayers out there saying what if the real estate market crashes and she can’t sell it? Well, the point was to buy a home and move in it to increase wealth by reducing living expenses. Instead of buying a move in ready home, she is building equity through renovations and in a better position than buying a move-in property immediately.
Also, she has a few exit strategies since she can sell the property for a nice profit even if it’s below $125,000 or she could rent it out for positive cash flow.
House hacking is the process of turning your current house into a money-making machine. Why pay to live when you can have someone else pay you? This is essentially the core of house hacking and something Taylor and I do now.
You can house hack a single-family home or a small multi-family home which is 2-4 units. Preferably you would want to house hack a small multi-family home so you can earn an additional income each month through renting or at least break even.
The idea behind house hacking a single-family home is to have someone live in the house with you as a roommate paying you rent. You’re acting as a landlord and a roommate at the same time and their rent helps pay your mortgage.
Let’s look at a few examples as to why small multi-family homes work better than single-family homes when house hacking.
We will start at the largest multi-family home you can purchase with a small down payment FHA loan, a Quad-plex or 4 unit property. With a quad-plex, there are 4 units, and you live in 1 of them while renting out the other 3. You are the landlord and your tenants pay you rent each month.
Let’s say Nancy found a $300,000 quadplex in a decent neighborhood.
With triplexes and quadplexes, you need to put 20% down at the time of purchase unless you use an FHA loan.
With an FHA loan, you can purchase a property with as little as 3.5% down, however, you to pay an upfront mortgage insurance premium (essentially a 1.5% fee for using FHA).
You will also have to pay PMI for the life of the loan unless you refinance once you get 20% equity. This is not the same as a conventional loan where you eliminate PMI automatically once achieving 20% in equity.
If Nancy took out an FHA loan her up-front costs are 3.5% of the purchase price for the down payment plus the additional closing costs. After purchasing she could expect a mortgage of $2,100 – $2,200.
For the purpose of simplicity, let’s say the other units in the quadplex rent for $1,000 each. If she has the three units rented with tenants, she can collect $3,000 in rent each month from her tenants.
$3,000 is roughly $800 more than her mortgage each month! Now, Nancy is getting paid to live!
Comparing this to her current situation of renting a 1 bedroom, $1,500 apartment, she now is no longer spending $1,500 each month or $18,000 per year.
With this solution, she increased her income by $7,200 from her tenants each year and no longer pays $18,000 in rent! This is a $25,200 swing, not including her tax benefits from becoming a real estate investor.
The same example above applies to triplexes and duplexes, but you’re less likely to profit as much compared to a quadplex.
Let’s take the same scenario above to a triplex, which is a little cheaper than a quadplex.
Nancy purchases the triplex for $250,000 and lives in one unit while renting out the other two. She can make $1,000 per month in rent from each unit. If her mortgage is $1,900-$2,100 she can bring in $2,000 in rent each month and live for free or nearly free!
With this solution, she technically increased her wealth by $18,000 per year since she’s no longer spending that on rent and breaking even on her triplex!
Taylor and I currently house hack a duplex. We bought the duplex with an FHA loan but then quickly refinanced when we realized we could have bought a duplex with a 5% down conventional loan. Refinancing helped us reduce our monthly payment and eliminate our monthly PMI (we paid it off upfront).
We currently pay $1,898 for our mortgage and our tenants pay us $1,200 a month, effectively bringing our mortgage costs to $700. This is the cheapest housing we ever paid since graduating from college and were able to live at the beach.
When we’re ready to move out we expect our unit to rent for at least $1,300 bringing us a monthly rental income of $2,500. With $2,500 coming in each month from rent, we will hopefully profit $600 a month or $7,200 per year from the duplex after paying the mortgage, insurance, and taxes.
In Nancy’s scenario even if she bought a $250,000 duplex she would still be much better off than renting. Let’s assume if a duplex costs $250,000, the same price as a triplex above, then it’s in a nicer area or more updated so the rents are $1,250 each.
Nancy purchases the duplex for $250,000 and lives in one unit while renting out the other one. She can make $1,250 per month in rent from each unit, however since she lives in one, she only collects rent from one unit.
If her mortgage is $1,900-$2,100 and she brings in $1,250 in rent each month, she lives in her own place for $650-850!
With this solution, she would technically increase her wealth by an additional $8,000 per year since she’s reducing her housing costs from $18,000 in rent to roughly $10,000 owning a duplex!
Also, she will increase her net worth because her tenant will help her pay off the mortgage increasing her equity in the property. After a year or two, she could move out and rent out the other unit receiving positive cash flow each month.
As you can see from the examples above, the ability to reduce your living expenses can immediately increase your wealth. Notice how I am stating increase your wealth and not your income.
The biggest expense according to the Bureau of Labor and Statistics is housing costs, which is roughly 33% of the total monthly spending followed by transportation at 17%. Reducing housing costs is the fastest way to increase your wealth. NOT by getting a raise.
Remember when you get a raise your raise is pre-tax, and depending on what tax bracket you fall in, you will only see 70%-75% of it. By reducing expenses, you see an immediate increase of wealth post-tax, so $10,000 in yearly savings is actually $10,000 in your pocket!
The best method to start your journey to financial freedom is to house hack. House hacking a multi-family home, preferably a tri-plex or quad-plex, is the best solution, followed by a duplex.
If you don’t have enough capital for a property than your best solution is to reduce your living expenses, try finding a roommate to start or move into a cheaper apartment. This will help put money back in your pocket each month that can go towards an investment.
Now I don’t mean to sound arrogant or harsh, but here are some excuses you should avoid at all cost if you want financial freedom.
Overall if you can reduce your housing costs then you’re already way ahead of the herd.
Reducing your housing costs offers plenty of opportunities to reinvest the money you saved into another project, one that will create even greater returns.
I hope this sparked a fire and changed your mindset towards increasing your wealth. It’s the snowball effect, it only takes the first step to get started and once you get one property, you’ll be hooked!
If you have any questions or comments, please leave them below!
When I first bought my duplex, I received many comments (mostly negative) challenging the action...June 12, 2019