January 26, 2012

Low Cost of Living versus Higher Wages

One common idea in personal finance is that it is beneficial to live in an area that has a lower cost of living.   Keeping your expenses lower is a basic tenant of financial success.   Living in a lower cost area can have a huge impact on your finances.    The other side of this however is that wages are generally higher in the high cost areas and lower in the lower cost areas.    You could pit this as a choice between lower costs and higher income.   Whats better?   

Do you come out ahead living in a low cost city and earning lower wages or living in an expensive city with higher pay?

To examine this issue I decided to do a case study for one profession in a few cities.   I am arbitrarily picking both the profession and select cities to look at for my case study.

I'm going to look at one profession : Computer programmer.    I picked that because its close to my own career field and because I think its a relatively high wage job where pay rates also varies considerably from city to city.    If the wages for an occupation do not vary from city to city then its much more of a given that you'd do better in lower cost cities.   If your wages are relatively low then again it is much easier to come out ahead in a lower cost city.

I'm going to look at 4 cities that are in different cost categories :

Very expensive : San Francisco CA
Pretty expensive : Seattle, WA
Pretty cheap : Minneapolis, MN
Very cheap : Grand Rapids ,MI

Basically I chose these cities because San Francisco and Seattle are likely to have more programmers that get paid larger wage and then I chose Minneapolis and Grand Rapids as semi-random examples of lower cost cities to use as alternatives.    You might end up with entirely different results if you picked four different cities. 

Wage,  Housing and  Cost of Living

First lets look at how wages and cost of living compare for a computer programmer in the four cities.   Since housing is the largest expense, I'm going to pull that figure out as well.   I got average wage amounts for computer programmers for each city from the BLS Metro wage estimates for May 2010.  Median home prices are for Q3 of 2011 and I got them from the Realtor.org site from their metro median prices data.  (Direct file link).   Lastly I got the cost of living (COL) index figures from the Sperlings Best places cost of living site.

Here is the data :

Wages Median home cost of living
San Francisco $94,310 $491,000 185
Seattle $92,840 $286,000 149
Minneapolis $69,070 $160,000 108
Grand Rapids $63,420 $111,000 84

Now if you simply look at pay rates proportional to home costs or cost of living index then everything falls in line.  Pay versus COL goes up with cheaper cities and the pay versus home cost increases as well.   we can express the ratios of Pay versus COL and pay versus housing as follows:

pay/col pay/home
San Francisco  $510 19%
Seattle  $623 32%
Minneapolis  $640 43%
Grand Rapids  $755 57%

If we simply stop there then it would be a given that Grand Rapids is the best city because your pay / cost ratios are the best there.   But real life is not so easy.    The ratio between pay and cost of living doesn't really mean all that much.   What really matters is the amount of money you have left over after your expenses.  

Lets look at an example of how that works : Consider two hypothetical cities A and B.   Lets say wages are $100k in A and only $50k in B.   Then lets estimate that the cost of living in A is 125%  more than city B so that the COL's are A = 225 and B = 100.  Wages / COL would be A = $100k/225 = 0.44 and B = 0.5   The wage / cost of living ratio is better in the cheaper and lower cost B city.   However what if your basic expenses are only $35,000 in city B and 125% more for $79k in city A.   At the end of the day when you take your wages minus total expenses you're left with only $15k in city B and $21k in city A.   You come out ahead in the more expensive city even though expenses are 125% more and wages are only 100% more.

With this thinking in mind its more important to look at how much money you're actually left with after accounting for wages minus expenses.

Disposable Income after taxes and housing

I'm going to figure an amount for the disposable income after figuring taxes and housing costs. This is an estimate of what a computer programmer would be left with in each city after paying taxes and a home mortgage.

I used MortgageCalculator.org to estimate the monthly payment for a $100,000 home at about $820 including principal, interest and property tax.   (note that property tax varies widely so this is a simplification on my part)   I then multiplied by 12 for a years worth of mortgage payments. This is the total housing cost in each city based on buying a median price home.   I am assuming 100% financing which isn't too realistic nowadays but it negates the issue of having to deal with varying size of down payments.

I used the tax calculator at Money Chimp to figure the federal income taxes assuming a married couple with 2 kids and only the one income.    I also added 9% of wages to the taxes to account for FICA and state taxes.   I know that 9% is not very accurate and state taxes probably amount to more on average, but I had to arbitrarily pick a figure so I just went with 9%.

Wages Tax Home Disposal
San Francisco $94,310  $17,825  $48,314 $28,171
Seattle $92,840  $17,472  $28,142 $47,226
Minneapolis $69,070  $11,767  $15,744 $41,559
Grand Rapids $63,420  $10,411  $10,922 $42,087

Now we start to see something interesting.    First lets throw out San Francisco since its obviously too expensive to come out ahead though the wages are highest there.    After you pay your taxes and mortgage the programmers living in Seattle are left with more money than those in Minneapolis and Grand Rapids.   Of course you still also have to spend money on various other things so that will likely eat up Seattles gains, right?   Lets take a look.  Here are the more detailed cost of living figures for Seattle, Minneapolis and Grand Rapids:

Seattle Minneapolis Grand Rapid
Overall 149 108 84
Grocery 110 109 98
Health 116 102 95
Housing 243 106 55
Utilities 89 97 92
Transportation 114 110 96
Miscellaneous 122 114 93

If you look at the overall number or the housing umber that is where we see the largest variation.  Housing is almost 5 times as expensive in Seattle as it is in Grand Rapids.   But once you account for housing the other costs between cities only vary 10-20% more than not.   Housing cost alone inflates the overall COL considerably.   The cost of living differences with housing excluded are much less from city to city.

I'm going to use the Consumer Expenditure Survey to get national average estimates for how much households spend in the basic categories.   For example the CES says that the average spent on transportation is $7,677.    Using the national average as a baseline equal to 100 we can then calculate how much an average household is likely to spend on each category given the different cost of living index.   For example if the average for transportation is $7,677 nationally and people in Seattle spend 114 index on transportation then we can estimate that Seattle residents spend 114 / 100 * 7677 = $8,752 on transportation and likewise if the index for transportation is only 96 in Grand Rapids then we can estimate that people there spend 96/100 * 7677 = $7,370.    I use this logic to estimate the spending for various categories in each city and then sum up the totals. 

Here are the total average household spending estimates normalized to the cost of living index for each category for the cities :

Seattle Minneapolis Grand Rapid national
Grocery $3,986 $3,950  $3,552 $3,624
Health $3,662 $3,220  $2,999 $3,157
Utilities $3,257 $3,550  $3,367 $3,660
Transportation $8,752 $8,445  $7,370 $7,677
Miscellaneous $8,932 $8,346  $6,809  $  7,321
SUM $28,589 $27,511 $24,096 $25,439

As expected it does cost more to live in Seattle but not by a wide margin.   When you set housing aside the spending  in the other major categories does not vary as greatly.

Now lets put it all together and see how much you are left with after paying your taxes, paying a mortgage and then spending an average amount on other categories.   We can do that by taking the disposable income after taxes and mortgage figured above and then subtracting the sum of other spending in the last table.

After tax & home Other spend Net Saved
Seattle $47,226 $28,589 $18,637
Minneapolis $41,559 $27,511 $14,048
Grand Rapids $42,087 $24,096 $17,990

That 'net saved' amount is the bottom line you would be left after :

Wages - taxes - mortgage payment - sum of other spending = net saved

By this estimation you actually come out ahead in Seattle.    Surprised?

There are several things that should be noted and kept in mind.  

This won't happen for any occupation or any city.   As I said early on if your wages are much lower then you'll generally do better in the low cost city.  I'd much rather try to live on minimum wage in rural Michigan than in Seattle.    Where the jobs are matters too.   Just because housing is cheap in the Midwest doesn't mean you can find a job there in your field.  I'd rather be gainfully employed in high cost San Francisco than be unemployed in Michigan.    I used average wages, median home values and average spending for other categories, but individuals are not average.   Everyone's spending behavior is different and you should figure out how spending and costs would impact you rather than look at what the average American spends.

Remember how I picked a low amount for the FICA and state taxes?    You might now point out how that alone could throw everything off.   Being off 1-2% on the state tax rate would mean Seattle falls behind.  I would point out that Washington state is one of the few states with no state income tax.   So, figuring actual tax burden may put Seattle even further ahead.   It is more analysis than I care to do today and thats why I simplified it by picking an arbitrary number.    It is important to keep in mind that if you were to do a real comparison for yourself then you should really figure the actual tax burden for each city in question based on the state and local tax rates.

The points I'm trying to make are :
The answer isn't as simple as finding the lowest cost city or comparing the wage / cost of living ratios.   The more important factor is the amount of money left after expenses are taken out of wages.
You really have to scrutinize individual occupations in specific cities and there aren't any broad rules that tell us if you'll do better financially in a cheaper city or a higher cost area.

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