5 Financial Decisions That Make or Break Middle-Class Americans

Yeah, yeah—this is another “list” related to finance. Here’s the deal. There are countless articles and books out there for folks who struggle with money. Most of those focus on things like “avoiding bad debt” and “saving for retirement.” This article is not for folks who need a day one intro to personal finance.

This is for a professional who is basically responsible and earning a solid middle-class wage but wants to identify the biggest levers in their financial position and make a good to great choice in each area. If you make good or great decisions around the five areas I describe below, I believe you will have a high probability of generating a net worth of $3 to $5MM or more over a working career.

Honestly, to get somewhat rich—$3 to $5MM or more—on a median salary over a 30- to 40-year career, you don’t really have to be that good with money. I really believe that. You simply have to make a couple of reasonable decisions, the earlier the better, and not make a couple of critical mistakes. But if you decide to do at least a moderate amount of research and make a couple of great decisions, again the earlier the better, you have a real shot at building a huge net worth and having incredible options later in life.

With that, let me walk you through the five decisions that I believe will propel a middle-class American to a sizable fortune over a few decades—or inversely, less optimal decisions that can leave them struggling throughout life to stay afloat.

The 5 Financial Decisions that Make or Break Middle-Class Americans

Decision No. 1: Housing

No surprises here. Housing is the largest single expense category for middle-class America. It’s just about a third of total household spending and a serious killer for wealth accumulation. Optimizing in this area will, for many people, be the single best step toward long-term wealth generation. This will likely be true of all but a select few who are particularly savvy or aggressive investors and possibly entrepreneurs.

The least optimal approach: Buy or rent the nicest, best situated place that you can qualify for financially.

While there is a sliding scale here (especially for pricier cities), this means that if you are spending more than a third of your monthly paycheck on housing (rent or mortgage plus average home maintenance costs), you are likely in this category.

When you rent at the top end of your price range, you are simply blowing money. I won’t bore you with the reasons behind why that is a bad decision. More interesting are the reasons behind why buying a high-priced home is bad for your financial position. When you buy a home that stretches you to your financial limits, two things happen:

Your current liquidity (cash or similarly easy-to-spend assets) are wiped out.
Your monthly cash outlays usually drastically increase. Typically through the mortgage (principal, interest, taxes, and insurance) payments and the often-overlooked maintenance costs that come with owning a home. There are the small, regular maintenance items, as well as the large, infrequent expenses.

The end result is that folks take on a highly leveraged position against an asset that will typically increase in price slowly—at the rate of inflation—and in the process, use up all or most of their liquidity and take on a huge monthly liability. Housing is also illiquid, meaning that it typically can’t be sold quickly and without high transaction costs (approximately 6 percent of the sale price is paid to buyer/seller agents alone, and that’s just a start to transaction costs).

All of this means that the homebuyer purchasing property at the top of their household price range is stuck—they can’t move, they can’t quit or change jobs in many cases, and they have a greatly reduced cash reserve, leaving them vulnerable to the vagaries of life.

The most optimal approach: Live with roommates; “house hack” by buying a place and renting out rooms or additional units (like a duplex, triplex, or quadplex); or “live-in flip” by buying a fixer upper, moving in, improving the place, and selling a few years later—greatly increasing your odds of generating a huge tax-free profit.

All of these choices significantly negate the consequences associated with the former decision and allow for a flexible approach to major life decisions outside of housing down the line. And yes, all of them involve a very real change in lifestyle—a sacrifice. The cost-benefit analysis is for you to decide.

A good middle ground: Purchase a home or rent a place that costs one-fifth or less of your after-tax take-home pay.

No, perhaps you won’t be able to live in the cool part of downtown in your favorite city, but you will quickly reap the rewards of a dramatically faster rate of wealth accumulation if you make such a housing decision.

The stakes for your housing decision are likely the highest of the five decisions I list today. For most Americans, no other financial decision will have as great an impact on lifetime wealth accumulation as the choice you make in the first place, or few places, that you choose to live.

Decision No. 2: Transportation

Transportation expenses, including car transportation, public transit, and airfare, are the next largest category of expense for most Americans. Some simple decision-making in this arena can save you tens of thousands of dollars over a 10-year period, and hundreds of thousands of dollars over a career.

The least optimal approach: Purchase or lease a new high-end luxury vehicle.

A new car will depreciate 20 percent the moment you drive it off the lot and an additional 40 percent (60 percent cumulative) over the first five years of vehicle life. Leasing the vehicle is even worse.

The optimal approach: Forgo a vehicle entirely or buy a well-researched, older model with a solid life expectancy in spite of its advanced age.

A good middle ground: Purchase a 5-ish-year-old model of an economy vehicle that you will enjoy driving.

Maintain it well, and shorten your commute as much as is practical to avoid putting unnecessary mileage on it.

Overbuying on your vehicle purchase is inefficient, bad math. No matter what you drive, you will likely adapt to it after just a couple months. Insurance, maintenance, registration, and depreciation are all significantly more expensive in the first five years of a vehicle’s life. Let someone else pay a premium for that, and enjoy a model that is a little older and a lot cheaper. It will still get you from A to B, but in a short period of time, you’ll be considerably richer.

As a bonus, make sure to research travel rewards, such that you are able to score a couple of cheap or low-cost flights and hotels for those vacations or life events that you may fly to a few times per year.

Decision No. 3: Career

I can’t help but think that a shocking number of career decisions are made on a whim. Think back to high school and college. What influenced your decision on whether and where to go to college? What influenced your selection of a degree/major/minor? What influenced the decision to go work for your first company? Was it a conscious set of choices that led to your current job, your current desk, your current location? Or did life take you there?

If you are like me (the start of my career, specifically), much of that process was reactionary. The person who wanted to be a doctor, lawyer, or accountant and knew so from an early age is the exception, not the rule. For many of us, the selection of a career has more to do with circumstance, with decisions made as teenagers reverberating through the decades.

If you are in a career making a median income or close to it and either dislike or are apathetic enough about your job where you would leave it the moment you achieved moderate financial freedom, then you need to think long and hard about what got you there and where your career is taking you.

Related: How Much Money Do I Need to Retire?

The least optimal outcome: Work a job with poor prospects relative to your potential, where you are underpaid and where you are in a lousy environment that you don’t enjoy. Maintain ignorance about what your skillset is worth in your local market, and remain unclear about what advancement opportunities may or may not be in store for you.

The most optimal outcome: You are currently well paid, enjoy your work environment, and you have a clear picture of the work you would like to be doing. You have a realistic, well-researched understanding of what best-case scenario pay is for that future position. You continuously network and take steps on a quarterly basis year after year with deliberate intent to move toward your long-term career goal.

A good middle ground: Write down your current pay, benefits, and career prospects, and be brutally realistic with yourself as to the odds of improvement in the coming years and where you stand in relation to your current market value. If there’s a meaningful discrepancy (people with your experience have significantly advanced titles/salaries in your market), put yourself in a life position where you are comfortable interviewing at other companies or asking for appropriate title/comp change.

You likely spend most of your waking hours preparing for work, at work, and returning from work. What is your strategy with your career? Why would you voluntarily show up to something that you do not like, especially if you are accepting a lower paycheck than you could otherwise find in your market?

A surprising number of people seem to have no serious career plan, dislike their work, and are underpaid relative to their current skillset! This is a short-, medium-, and long-term loss. If this is even partly true for you, be honest and set about fixing this situation. There are myriad careers that pay well, offer great prospects, and do not require a college degree. You may be surprised at just how cheap the switching costs are.

As an aside, many people find themselves in this position partway into a career because they paid too much for housing, too much for their vehicle, and do not have a cash cushion capable of supporting them through any periods of no or reduced income while they contemplate their next career moves.

The costs of mismanagement in those other areas of finance force them into a liquidity trap, which makes the uncertainty and risks of losing income by taking time to find a new job or the risk of losing their current job unacceptably high. Because they live effectively paycheck to paycheck, these folks don’t have the option to take even a slight reduction in base pay for greater opportunity.

Don’t let that be you.

Decision No. 4: Your Investment Approach

If you make great decisions around your housing, transportation, and perhaps in your career, you will be able to pile up a surprisingly large amount of money in surprisingly short order. The next best way to lose in the game of long-term wealth accumulation is to abdicate decision making when it comes to investing and put your money in historically poor-performing asset classes and investments.

The least optimal approach: Not investing at all.

OK, we know this, so let’s move to the next worst thing.

Closely following the decision not to invest is the decision to invest in something you don’t understand just because a figure in your life told you to do it. Many people cannot tell you what they invest in inside their 401(k). They might own mutual funds, individual stocks, or REITs. But they couldn’t tell you why they are invested in each asset, can’t describe the breakdown of what they are investing in at a deeper level, and don’t understand the fee structure associated with their investments. They also have no long-term philosophical approach to investing. Rather, they make one-off decisions with little research or understanding behind those decisions.

The most optimal approach: Understand and have clear rationale behind why you are making every investment decision, and be able to articulate exactly what is in every part of your portfolio and why it is there.

The most optimal approach is to read, listen, watch, or otherwise consume a material amount of investing and personal finance content from a variety of sources. Make this a life-long, or at least career-long, pastime. Then, arrive at a sound, long-term investing philosophy and stick to it through the ups and downs of the market. Invest with the end in mind, in a manner that makes the most sense to you.

The optimal investing approach may vary considerably depending on where you live, what you do for a living, and how much effort you choose to put into your portfolio. For example, I have investments in real estate in Denver, Colo. I also invest in index funds, I invest in small private businesses—like the one I work for—and I have a book (partly about investing, yes) that I wrote that produces royalty income.

A good middle ground: If you are unwilling to do the research above, a good balance is to assume mediocre investment returns over the long-term and gradually build out a portfolio that leans more aggressive in the early years (e.g., most of your investments in low-cost stock index funds) and more conservative in the years leading up to your retirement (e.g., a heavier weighting to bonds or other lower-risk, income-producing assets).

If you decide to do this, you should still pick up a book or two on investing, and invest a couple of dozen hours reading blogs, listening to podcasts, or otherwise educating yourself about high-level investing approaches.

Decision No. 5: Cash Cushion

This is likely to be the most controversial part of this post. Many people believe that holding onto a meaningful amount of cash (perhaps six to 12 months’ worth of expenses) reduces their ability to earn returns they might otherwise generate by investing this cushion. While that is true, I have come to believe that a significant cash cushion—12-plus months of expenses—is an excellent use of capital for the working middle class, a use that can produce significantly greater returns than all but the greatest investment alternatives.

The least optimal approach: Live paycheck to paycheck and/or have access to less than one or two months’ worth of liquidity.

If this is you, then you are in big trouble, and your life may be derailed by the next unexpected problem. The words “finance” and “money” will become synonymous with “fear,” and you will live in a state of stress. Ordinary and petty life problems like home and car repairs will threaten your lifestyle.

Everything you do and every financial decision you make will be in the context of playing not to lose. One mistake, and you are burned. You can’t watch your investments lose money, because your long-term investments are essentially your safety net both now and at retirement. You can’t purchase high-deductible (often far cheaper) insurance. You can’t make big purchases with the long-term in mind (think certain home improvements, your car purchase, your mattress, your tools, your cookware, your clothing, etc.).

The most optimal approach: Accumulate over one year of liquidity with which you have ready access.

This doesn’t have to be in cash, under your mattress, in a checking account, or even in a savings account. You could even “invest” your cash cushion in after-tax brokerage accounts in index funds if you are comfortable with the potential for huge volatility.

But having access to about one year of liquidity—liquidity which is specifically set aside for the purpose of giving you access to use it for life’s opportunities, challenges, and setbacks—will put your mind at ease and allow you to play the game of wealth accumulation to win, as opposed to not to lose, per the above.

You can make each of the countless day-to-day financial decisions that come up based on the long-term interests of you and your family when you have access to this kind of liquidity. You can invest for the long-term. You can remain at ease when your portfolio dips or you need a new car. You can rest assured you’re OK when you have a career opportunity, need to move, or have to take some time to care for yourself or your family. And when exceptional circumstances arise that create an investment opportunity, as they may from time to time, you can use this to make a calculated big investment bet.

A good middle ground: Aggressively build a three- to six-month cushion, and from there, slowly work toward building a full year or more of liquidity over time, balancing growing this cash cushion with regular investing according to your long-term investment philosophy.

It can take one, two, or even five years to build up to that position, and accumulating that much cash before taking other investing actions can be a burden on your long-term financial position. But if windfalls or opportunities come, or as your career progresses and your savings rate accelerates, keep top of mind the advantages of having a large cash cushion, and consistently build it.

The Bottom Line

I believe that these five basic areas of life have the potential to make or break middle-class America. Ask yourself—do you know anyone who:

Works a dead-end job but could easily find a better one and likely make more money?
Purchased a really nice home and is now effectively house-poor?
Drives a newer luxury vehicle but seems worried about money?
You suspect lives paycheck to paycheck, in spite of having a middle- or upper-middle-class job?
Doesn’t have a clear understanding of their investment portfolio?

I bet you don’t have to look too hard in your life to find someone who meets all or most of this description. This person will have a drastically different working career and retirement than their opposite, the American who makes conscientious choices in each of these five areas from the beginning of their career to the end of it. While I conservatively peg the career difference here at $3 to $5MM in incremental net worth, the difference could easily be $10MM or more over the next 30 to 40 years.

And to reiterate, of these decisions, the one that will have the greatest impact on your financial future is likely your housing choice. It’s also the decision that will be most difficult for the average person, because it’s the most meaningful change to your lifestyle. The good news is that, really, you just need to make a good or optimal decision on housing on your first home.

Make good decisions, as soon as possible, and you will be amazed at how you can achieve previously unfathomable financial goals. Fail to make these decisions with intentionality, and you will be a member of the tribe that decries the decline of the middle class in America today.

I wish you the best of luck, and hope this guides you on at least a few of the big crossroads you face in the years ahead!

How are you doing with regard to the five decisions outlined above? Are there any important financial choices you’d add to this list?

Let’s talk in the comment section below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.