The Overhang Theory: How to Live Below Your Means
Your expenses should never exceed your income.
The Overhang sounds like a mystery novel, doesn't it? Actually, there's a Michael Connelly book called The Overlook, but the overhang I'm talking about isn't a rocky outcropping from which the hero dangles by his fingertips. It's a principle of personal finance that is about to save me a lot of anguish. (Just like the helicopter that's about to appear and save our hero right before he loses his grip.)
Personal finance people talk a lot about the savings rate. In theory, the savings rate ought to be one simple number: How much am I saving compared to my income? In reality, it's a lot more slippery: are we talking about pre-tax or after-tax income? Is debt repayment the same as savings? Should we distinguish between short- and long-term savings?
The overhang is a lot simpler. It looks like this:
The size of your overhang is a measure of your ability to withstand a reduction in income. Reductions in income happen all the time, some by nasty surprise and some by choice.
I've borrowed this idea from one of my all-time favorite personal finance books, All Your Worth by Elizabeth Warren and Amelia Warren Tyagi. The key insight in their book is what they call the Balanced Money formula: From your take-home pay, 50% should go to necessities, 30% to wants, and 20% to savings.
Last year, a friend came to me for advice. She and her spouse have one child and, until recently, both of them worked in professional careers. My friend, who I'll call Gail, was sick of her job and wanted to start her own contracting business. I said great, but be realistic about how fast (that is, how slow) a new business is likely to grow.
Gail's family was used to a high standard of living, symbolized by a house with a beautiful garden. They were able to achieve this standard of living by spending all of their take-home pay on current expenses. They had no overhang whatsoever.
Once Gail quit her job, they started drawing down their emergency savings to maintain their lifestyle. In other words, the day she gave notice, a clock started ticking: Her new business would have to thrive by the time that money ran out, or else.
Last week, Gail hit the "or-else" moment. The savings are almost gone, but her family is still spending like a dual-income couple. She came to see me and we put together a simple budget spreadsheet. The first thing that jumped out at me was that their mortgage payment alone was close to 50% of their take-home pay. Lenders (post-housing bubble, at least) get very nervous when that payment creeps above 33% of income, and with good reason: It's unsustainable. You can't be financially agile, save for retirement, and have enough fun to stay sane when just one of your non-negotiable monthly payments is sucking up half your income.
I told Gail that unless she got her old job back (out of the question), there was no way they could stay in the house. I think she was just waiting for someone to say it out loud.
We set the spreadsheet aside and I asked Gail the big questions: Let's say you can have anything you want out of life as long as it doesn't require spending more money than you make? Would you be willing to live in a small apartment near your spouse's job?
I expected her to throw a drink at me, but to my surprise, she smiled. Sure, that could work, she said. She'd still have the most important thing - her family - and could say goodbye to constant worries about money.
The book The Millionaire Next Door came out in 1996. I resisted reading it for a long time because I figured it would be full of self-affirmational claptrap, and there is some of that, but it's mainly about a simple financial truism: no matter how much money you make, the only way to get rich is to spend much less than you earn. The millionaires in the book drive cheap, old cars, drink Bud rather than champagne, and pay off their mortgages early. They have huge overhangs.
Honestly, they also seem frustratingly immune to status anxiety. If everyone in your social group lives in a big house and drives a Range Rover, and you live in a two-bedroom and drive a '97 Camry, I imagine you get a lot of strange looks and miss out on invites to champagne-soaked bacchanals. Sure, you can be smug about the fact that you're saving money and your friends aren't, but people who proclaim loudly that they never try to keep up with the Joneses sound a lot like a politician loudly denying that he posted that picture on Twitter.
And I'm really talking about houses and cars here, not your drink of choice. When I get an email from a friend of a friend saying, "I have a financial problem," it's almost always because they're spending too much on housing, cars, or medical bills - the necessities All Your Worth warns us not to let get out of hand.
I do know is that it is possible, above a certain income level, to maintain a sizable overhang and live well below your means, because I know a lot of people who do it. It would be absurd to generalize about how happy these people are compared to their indebted peers, but I can tell you that accumulating a sizable nest egg through living small doesn't seem to be making them obviously miserable.
Not exactly a lesson
I've thought about this topic a lot, and I keep coming back to the same annoying conclusion: Lots of families spend all of their income (or more), and when they realize this is a problem, they try to cut back on small luxuries when they should be thinking about housing and car expenses - the elephants in the room. (And if we're talking about the average American suburban home, it probably does have a living room large enough to park an elephant).
What a useless observation, though, right? People make those kinds of changes in response to a crisis or life change (divorce, retirement, illness, job loss, to be near a sick parent), not as a preventive measure. It seems crazy to even talk about the idea of someone moving to a smaller house or trading in their car in order to bulk up their emergency fund or fund their 401(k ), even if doing so would probably make them happier in the long run.
So, please let me know if you think this insight is clever, crazy, or facile. I will read your responses aloud via my fancy phone at tonight's champagne party.
Editor's Note: This article by Matthew Amster-Burton was originally published on MintLife.
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