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Wednesday, July 17, 2024

Cracking the code on cost of living

Cracking the code on cost of living

09.12.2023

Life can be expensive. From major monthly expenses like housing to daily costs like groceries, where you live and how you spend can have a big impact on your long-term financial plan.

In this article we cover the basics:

  • What contributes to your cost of living
  • How your location plays a role, and how your state stacks up against others in average overall cost of living
  • What you can do to reduce your cost of living in order to build up long-term savings and minimize your financial impact

What is the cost of living?

“Cost of living” refers to the amount of money someone would need to maintain a certain standard of living and cover basic expenses like housing, transportation, food, and healthcare.

The cost of living in a particular area can have a significant impact on the quality of life in a particular area. It also affects local wages. Higher cost-of-living areas also typically have higher salaries.

Knowing the cost of living can be helpful for several reasons. First, it can give someone an idea of how much they must earn from a job to be able to afford a certain standard of living. It can also be a helpful tool for comparing multiple cities or regions. For example, if you’re considering a big move, local costs of living would likely be a factor you’d consider.

What are factors to consider when breaking down cost of living?

According to the Bureau of Labor Statistics (BLS), the average annual expenditure in the United States was $66,928, up 9.1% from the previous year.1 Here are the spending categories that make up the largest portions of those expenditures:

  • Housing: For most people, it’s the single largest line item in their budget. According to the BLS, housing makes up 33.8% of the average annual expenditure, or $22,624. This is slightly higher than the recommended 30% housing cost. And in high-cost-of-living areas, housing likely takes up an even larger percentage of wages. Reducing your housing expenses is one of the most effective ways to reduce your overall costs.
  • Transportation: Spending in this category can include vehicle payments, gas, public transportation, ride-sharing apps, and more. Owning a vehicle may be more common in rural and suburban areas, while many people in urban areas rely on public transportation. Transportation makes up 16.4% of the average annual expenditure — or $10,961 — and is a necessary expense for most people.
  • Food: Roughly 12.4% of the average annual expenditure is spent on food, for a total of $8,289 per year. It includes both groceries and food away from home. Food costs are higher in areas with higher costs of living. And while it’s a necessary expense for everyone, it’s also an expense that’s easy to adjust based on your household income.
  • Personal insurance and pensions: People spend roughly 11.8% of their total expenditures, or $7,873, on personal insurance and pensions. This category includes all personal insurance including, life insurance, and also includes money contributed toward pensions and Social Security.
  • Healthcare: For the average consumer, healthcare makes up about 8.1% of spending, which equals roughly $5,452. However, this category varies significantly between households depending on the presence of chronic health conditions or whether the family has health insurance.

Housing, transportation, food, personal insurance and retirement savings, and healthcare make up the top five spending categories for the average consumer. The BLS also includes the following expenses in its expenditure data:

  • Alcoholic beverages
  • Apparel and services
  • Entertainment
  • Personal care products and services
  • Reading
  • Education
  • Tobacco products and smoking supplies
  • Miscellaneous
  • Cash contributions

One expense notably missing from the BLS data is childcare which, according to Care.com, amounts to more than $9,600 per child in 2023.2 More than half of families spend more than 20% of their income on childcare, which can drastically affect their cost of living.

How does location affect the cost of living?

The cost of living varies across the country. Not only does the cost of living differ from state to state, but even within the same state, you can find cities with both high and low costs of living.

Suppose you’re considering a move from Kalamazoo, Michigan to Manhattan. If you had an income of $50,000 in Kalamazoo, you would need an income of $143,418 in Manhattan to maintain the same standard of living. The cost of living in Manhattan is about 187% higher.3

Housing makes up perhaps the most important difference between the two cities. The average rent in Kalamazoo, according to Rocket Mortgage, is just $647 per month compared to $4,630 in Manhattan. Similarly, the average home price of $263,783 in Kalamazoo is nearly one-tenth of the average home price of $2.49 million in Manhattan.3

Because of how drastically the costs of living differ from city to city, your financial planning will look very different in those cities. Someone in New York must take very different steps to ensure a comfortable life — both now and in retirement — compared to someone in Kalamazoo.

What is the cost of living index?

The Cost of Living Index (COLI) is a city-to-city comparison of the costs needed to maintain a certain lifestyle. This index can be helpful in determining how far your money will go in a particular city. Someone considering a move could use this data to decide where to call home.4

The Council for Community and Economic Research (C2ER) publishes quarterly COLI data using the cost of more than 60 goods and services collected from over 300 independent researchers around the country. It’s the only local-level COLI in the United States and is recognized by the U.S. Census Bureau and the Bureau of Labor Statistics.

The C2ER COLI is organized into six categories: food, housing, utilities, transportation, healthcare, and miscellaneous goods and services. It uses an average index of 100 and then publishes an index for each participating city compared to that average. Cities with low costs of living will have indexes below 100, while those with high costs of living will have indexes above 100.

The tables below show the ten most and least expensive urban areas in the United States, according to the C2ER Q1 2023 COLI5:

Most expensive  
RankingUrban areaCOL index
1New York (Manhattan), NY222
2Honolulu, HI179
3San Francisco, CA169.9
4New York (Brooklyn), NY159.1
5Orange County, CA150.3
6Los Angeles-Long Beach, CA149.1
7Washington, DC148.7
8Boston, MA148.4
9Seattle, WA144.5
10San Diego, CA142.5
Least expensive  
RankingUrban areaCOL index
1Harlingen, TX75.9
2Decatur, IL77.6
3Muskogee, OK80
4McAllen, TX80.9
5Tupelo, MS81.7
6Lawton, OK82.5
7Kalamazoo, MI82.9
8Ponca City, OK82.9
9Pittsburg, KS83.1
10Conway, AR83.2

What are cost of living adjustments?

A cost of living adjustment is a change to your salary and benefits based on the local cost of living. Just as the cost of living differs significantly across the country, so does the average salary.

For example, though San Francisco may be one of the most expensive cities in the country, its median household income is $126,187.5 Meanwhile, the median household income in Muskogee, a city with a much lower cost of living, is just $41,430.6 Therefore, the local cost of living isn’t necessarily the only factor that determines your standard of living.

Companies often consider an area’s cost of living when setting wages for local employees. In fact, many remote companies pay employees in the same job a different salary based on where they live. Two people working for the same company in the same role could have an entirely different pay scale because of their location.

Additionally, many companies offer cost of living adjustments annually to help employees’ wages keep up with inflation. Similarly, the Social Security Administration offers a cost of living adjustment for those who receive retirement and disability benefits.

Which states have the lowest cost of living?

Mississippi, Kansas, and Alabama are the three states in the U.S. with the lowest costs of living. Below you’ll find each state’s Cost of Living Index5, as well as how they rate in specific categories.

Mississippi

  • COLI: 83.3
  • Groceries: 92.2
  • Housing: 66.3
  • Utilities: 90.4
  • Transportation: 86.7
  • Health: 94.7
  • Miscellaneous: 90.9

Mississippi has the lowest cost of living of any state, partially due to its affordable housing and transportation. It has a median home price of $140,818, which is significantly lower than the national average. However, Mississippi also has a high poverty rate at nearly 20%.

Kansas

  • COLI: 86.5
  • Groceries: 91.7
  • Housing: 72.6
  • Utilities: 100.2
  • Transportation: 97.3
  • Health: 100.4
  • Miscellaneous: 88.4

Despite having an above-average index for utility and healthcare costs, Kansas is the second-cheapest state in the country to live. It has affordable housing — the average single-family home is just $176,898, while the average two-bedroom apartment rents for $995. Unlike Mississippi, Kansas also has a low poverty rate and low unemployment rate (2.5%).

Alabama

  • COLI: 87.9
  • Groceries: 98.2
  • Housing: 70.1
  • Utilities: 100.7
  • Transportation: 92.7
  • Health: 91.2
  • Miscellaneous: 94.3

Alabama has the third-lowest cost of living in the country. Like Mississippi and Kansas, Alabama has affordable housing. The average single-family home price is $170,184, while the rent for the average two-bedroom apartment is $1,046. However, like Mississippi, Alabama also has a high poverty rate of 15.6%.

Which states have the highest cost of living?

On the other end of the cost of living spectrum are Hawaii, New York, and California, which are the three most expensive states in the country to live in.

Hawaii

Hawaii is the most expensive state in the country to live in, with a Cost of Living Index of 193.3, nearly twice the national average. Hawaii has notably high housing costs, which are roughly triple the national average. Additionally, given the cost of shipping goods to the islands, groceries are significantly more expensive.

Despite Hawaii’s low cost of living, it actually has a relatively low poverty rate — it’s lower than any of the three states with the lowest costs of living.

New York

New York has a Cost of Living Index of 148.2, which is the second-highest in the country. You’ll notice that despite being the second most expensive state, New York is still significantly lower than Hawaii on the Cost of Living Index. This is because while all of Hawaii is expensive, the entire state of New York isn’t very expensive — New York City has considerably higher costs than the rest of the state.

New York has an average housing cost that’s one and a half times higher than the national average, and housing is even more expensive in New York City. That being said, New York has a poverty rate that’s higher than the national average, and wages aren’t as high as they are in the other most expensive states. In fact, New York City has a median household income that’s only $1,000 lower than the national average.8

California

California is the third most expensive state in the country, with a Cost of Living Index of 142.2. The state has housing costs that are twice the national average, and costs are considerably higher in expensive areas like San Francisco, Los Angeles, and Orange County.

California has a median household income that’s quite a bit higher than the national average. However, it also has a poverty rate that’s slightly higher than the national average. Additionally, the state has the highest rate of homelessness of any state, falling behind only Washington, DC.9

Why is it important to compare the cost of living?

Whether you’re planning to move or want to stay in your current city, knowing the cost of living has plenty of benefits.

First, comparing the cost of living across various cities or regions can help you if you’re considering a move. Imagine you’re a recent college graduate who is deciding where to start your career. The Cost of Living Index could be a valuable tool in helping you decide which cities to look at (and which to avoid).

Of course, make sure not to look only at the cost of living. Cities with high costs of living may also have higher average salaries, which could make the increased costs more than worth it.

Another way you can use the cost of living is when negotiating a salary. If you’re relocating to a new area or starting a new job and living in a high-cost-of-living area, you could use a higher cost of living to negotiate a higher salary.

Read more: Why a six-figure salary no longer means you’re rich

Finally, knowing the cost of living in a particular area can be helpful if you’re planning to buy a house there. Housing is one of the most important components of the cost of living. And in many high-cost-of-living areas, it's usually the housing that makes them so expensive.

When you’re shopping around for a house, first find out the average house price in your area. You can decide whether you feel comfortable spending more than that and can keep that number in mind when comparing list prices.

Economic and other factors to consider for financial planning

Cost of living is just one economic factor that you should consider during your financial planning. Keep reading to learn more about other factors to consider and how to use those factors to develop your financial plan.

Macroeconomic factors to be mindful of

One of the most important factors that will affect your personal finances is inflation, which is the rise in the cost of goods and services. While inflation isn’t inherently a bad thing — in fact, a lack of inflation would also be concerning — it does affect your purchasing power. In the past several years, the United States experienced high inflation, which put a strain on people’s budgets.

Another macroeconomic factor that impacts your personal finances is interest rates. The Federal Reserve raises and lowers interest rates in response to the economy. During times of high inflation, as we’ve experienced during the past few years, the Fed increases interest rates.

Interest rates, as they are in 2023, are considerably higher than they were just a few years earlier, especially during the pandemic. These higher rates also affect purchasing power.

When interest rates are higher, debt, such as mortgages, auto loans, credit cards, personal loans, and student loans are more expensive. People are likely to see their budgets take a hit with the extra money they’re spending on interest and may not be able to purchase as expensive of houses and vehicles as they would during periods of low interest rates.

Developing a plan to minimize financial impact

Unfortunately, consumers have little to no control over macroeconomic changes such as rising inflation or interest rates. However, there are still steps you can take to adjust your financial plan. When inflation is high, you may need to revisit your budget. Certain parts of your budget, such as groceries, may need to be increased to keep up with rising costs. Meanwhile, you may need to decrease other parts of your budget to accommodate for those other increases.

Some good news is that when inflation is high, cost of living adjustments at companies may be higher. Additionally, the Social Security Administration increases benefits when the cost of living rises.

Adjusting cost of living calculations

When you’re looking at cost of living data, it’s important to consider how it changes based on your family size. The average expenditure data from the Bureau of Labor Statistics says the average household has 2.4 people, which contributes to the average household spending.1

On the other hand, some cost-of-living calculators are based on the expenses of a single person. If you’re using a cost-of-living calculator, pay attention to the household size considered so you can adjust it based on your own family.

Read more: The cost of being single

Necessary vs. discretionary spending

A final important conversation to be had regarding the cost of living is the difference between necessary and discretionary spending. The Bureau of Labor Statistics average annual expenditure includes both necessary and discretionary spending.

The higher your income — especially when compared to the cost of living in your area — the more you’ll be able to spend on discretionary expenses. On the other hand, someone with a low income compared to their local cost of living will have little left to spend after paying for necessary expenses.

Read more: Variable expenses vs fixed expenses: What’s the difference?

Necessary spending: meeting essential needs

Necessary expenses are those that meet your essential needs. They include housing, food, utilities, transportation, and healthcare. These expenses can’t be avoided and must take priority over discretionary spending in your budget.

In some high-cost-of-living areas, people spend a larger portion of their incomes on necessary expenses (especially housing).

Discretionary spending: non-essential costs

Discretionary expenses are those non-essential costs in your budget. They include any spending above and beyond your basic needs, such as recreation, entertainment, luxury goods, and travel.

It’s worth noting that some spending categories fall into both necessary and discretionary expenses. Food, for example, is a necessary expense. However, buying the most expensive products at the grocery store or eating at restaurants would be considered discretionary spending.

Factors influencing discretionary spending

Your location plays an important role in determining how much you can spend in discretionary spending. If you live in a high-cost-of-living area, you may have less left over to spend on non-necessities. On the other hand, someone earning a decent salary and living in a low-cost-of-living area might have more available to spend.

Another factor that influences your discretionary spending is your income. Generally speaking, the higher your income, the more of your budget you’ll be able to allocate toward discretionary spending.

Finally, some of the macroeconomic factors we discussed previously can impact your discretionary spending. As inflation and interest rates rise, you might find that your discretionary spending must go down.

Balancing necessary and discretionary spending

Striking the right balance between necessary and discretionary is challenging, but it’s also vital if you’re going to meet your financial goals. Overspending on discretionary items can result in too little money left over for important savings categories like your emergency fund or retirement.

There are some budget systems specifically designed to help solve this problem. For example, the 50-30-20 budget recommends spending 50% of your income on needs, 30% on wants, and the other 20% on savings and debt. This method ensures you have some money going towards savings no matter how much (or little) you earn.

However, the 50-30-20 budget doesn’t necessarily work for everyone. Someone with a low income in a high-cost-of-living area may struggle to spend only 50% on needs. Especially given that, with the high housing costs in certain areas, many people spend 50% of their income on housing alone.

Read more: 7 short-term financial goals to achieve this year

How is the cost of living calculated?

Cost of living data such as the C2ER Cost of Living Index using complex weighted price data in multiple categories collected from hundreds of data sources. While it’s not math someone could easily do themselves, there are online cost-of-living calculators that can help you estimate your total cost in a particular city or town. These calculators can be useful when deciding where to move or buy a home.

1 Bureau of Labor Statistics, “Consumer Expenditures in 2021,” January 2023.

2 Care, “This is how much child care costs in 2023,” June 2023.

3 Data as of August 2023; Rocket Mortgage, “Cost Of Living Calculator: How To Use It And FAQs,” February 2023.

4 The Council for Community and Economic Research, “Frequently Asked Questions.”

5 The Council for Community and Economic Research, “Quarter 1, 2023 Cost of Living Index Released,” May 2023.

6 U.S. Census Bureau, “ QuickFacts San Francisco city, California,” July 2022.

7 U.S. Census Bureau, “ QuickFacts Muskogee city, Oaklahoma,” July 2022.

8 U.S. Census Bureau, “QuickFacts California; New York city, New York; United States; New York; Hawaii,” July 2022.

9 Statistica, “Estimated rate of homelessness in the United States in 2022, by state,” June 2023.

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William S. van Valzah lll, CRPC®

Contributor

William S. van Valzah lll is a Senior Financial Professional at Empower. A Chartered Retirement Planning Counselor, he is responsible for  holistically understanding clients' needs and providing financial insight to help them make informed decisions.

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