When we talk about FIRE (financial independence, retiring early) one of the most crucial things to understand aside from saving is compound interest. As Einstein once famously said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.” – Albert Einstein
Well said (Pretty smart guy!). Let’s put it this way:
- If you are borrowing money, someone wants to be remunerated for being so kind;
- If you are lending money, you most likely want to be rewarded for your generosity;
These are two sides of the same coin. If you are lending, you want to be compensated for:
- Time value of money ($1 today is worth less than $1 in 10 or 15 years for example);
- The risk that whoever is borrowing the money, will not be able to pay you back (either on time or in full);
Makes sense right?
So let’s go through a compound interest example. Let’s go with the following assumptions:
- 30 year old Mr. Consumer wants to retire at 45 (In fifteen years);
- Mr. Consumer feels that for his 30th birthday, he should treat himself to a nice luxury sedan for $30,000;
- Assume he has $30,000 in cash (most people finance a car but for this example, lets simplify things);
- Assume he could make, net of inflation, 7% by investing in various companies through the stock market;
- Simplifying, let’s removing ongoing costs of a luxury car (make no mistake, these are SUBSTANTIAL over time);
Mr. Consumer has a CHOICE with that $30k…
Choice 1: He can buy that luxury car, and pay ongoing via headaches, financial stress, and added costs (insurance premium, gas, repairs, licensing, etc.)
Choice 2: He can invest that money and earn compound interest. Should he choose to invest that $30k, Mr. Consumer stands to grow that capital to $82,771. A nice addition to his retirement nest egg.
That $30k will earn, on average, 7% per year over a long-term time horizon. Interest earned:
- Year 1 = 2,100. Now for year 2, he has 30,000 + 2,100 = 32,100.
- Year 2 = 32,100 x 7% = 2,247.
- Year 3 = 34,347 x 7% = 2,404
- …Year 15 = 77,356 x 7% = 5,415.
So you can see that interest is earned on interest, i.e., compounded. The effect is EXPONENTIAL. A $30k decision is truly an $83k decision in this scenario.
That’s retirement money. Thats independence money. That’s what’s known as f%$k you money (when you can finally retire from a job you may not completely be in love with). That’s money that will allow you to have choices, and the freedom to make those choices.
I think most people think in terms of monthly sustainability, which is an issue as you’re not looking at the opportunity cost. Opportunity cost is what you are giving up when making a choice.
“But it’s $30k that I can finance at 0% over 60 months! It’s nothing compared to my take-home pay!”
Yes, that $30k is then split into $500 a month which some folks compare to their take-home pay and say they can afford it. You probably can’t.
When people think on a monthly basis, they are too deep in the weeds. You need to think BIGGER PICTURE. You should be examining the long term effect of your choices. Long term is subjective and depends on when you want to achieve FI (financial independence) so that could be 5 , 10, or 15 years.
Whatever your timeline, know the impact of your decisions.
Let’s spice it up and say we are looking at ongoing costs as well since in reality that’s what you’re signing up for – what would that look like? Using the Driving Costs Calculator from http://www.caa.com/carcosts/ for a 2018 Audi A3 4D Sedan 2.0T averaging 20,000km a year*:
$4,707 PER YEAR**
Wow what an awful choice Mr. Consumer has made!
That would be an additional opportunity cost of $118,282 if that money could have been invested at 7% per year instead. So what does that $30k luxury car cost you over 15 years?
TOTAL = $82,771 + $118,282 = $201,053
*I chose the Audi A3 sedan as the MSRP was $33k – $45k…a little higher than my $30k example but close enough.
**Note this excludes expected depreciation of $4,930 per year. I did not include depreciation as the opportunity cost of the vehicle itself resides in the $30,000 price tag.