There is a lot of focus on how we Americans can save money, especially in this economy. Clip coupons for the grocery store, pay off a credit card balance every month to avoid finance charges, brown bag your lunch, make your own coffee at home instead of buying a brew at Starbucks, only use an ATM card “in network” to eliminate extra bank fees, buy the cheapest cable package, etc. There’s no argument that following these strategies can indeed save us money. But the question is, just how much money do we save, and is there a simpler/lower effort way to save even bigger bucks? The answer may surprise you.
Let’s call it the “one-fifth rule.” It applies to two of the biggest purchases we make in our lifetimes: our cars and our homes. Here’s how the rule works: determine the maximum amount you can reasonably spend on either of these big purchases, and then reduce that amount by one-fifth. For example, let’s say you want to buy a new (to you) car, you’ve looked at your budget and figure you can afford to spend $25,000. Rather than spend that amount though, you cut it by one-fifth ($5,000 in this example). So you decide the most you’ll spend on a new vehicle is now $20,000. Maybe that means instead of buying a brand new car, you now have to buy a good-quality used car. Is that such a tough sacrifice to make?
Think of it this way. Let’s assume you’ll keep the car for five years and then buy another. By dropping the price by $5,000, you’ve saved $1,000 per year, which works out to about $80 per month. With the $80 per month, you can buy your coffee on the way to work, or go out to lunch a time or two each week, or upgrade your cable package—you get the idea. Whatever “fun” high-frequency purchases you want to make you can now afford, without guilt, because you saved big money in one fell swoop on a used car. No more worries about tracking these smaller expenses that may bring you more satisfaction each day/week than that new car that may have cost you $5,000 more. Make sense?
Apply the same logic to your next home purchase. Let’s say the bank qualifies you for a maximum loan of $200,000. But rather than apply for loan that size, you apply the one-fifth rule and reduce your maximum borrowing to $160,000. On a 30-year loan at say 4.5% interest, you’ll save about $200 per month by taking the smaller loan. The big challenge is finding a home you’ll love for $40,000 less. But if you can, imagine the reduced pressure that lower monthly payment will have on your cash flow—less stress, you’ll no doubt come to love your new (less expensive) home in short order, and you’ll have enough wiggle room in your budget to enjoy life’s little comforts without feeling guilty and without needing to scrimp on the smaller expenses of your everyday lifestyle.
The one-fifth rule is especially appropriate for folks in their 50s and 60s heading into retirement. Many studies estimate we’ll need about 80% of our pre-retirement income in our retirement years. By applying the one-fifth rule to two of life’s biggest expenses, you’ll be well on your way to a more comfortable, secure retirement. The one-fifth rule is a simple way to maximize your retirement readiness.