Compounding Coffee
The next time you have the urge to buy something to quench your thirst, don’t. Instead, take the money you would have otherwise spent on a coffee, a coke, or a beer, and directly invest it. It might sound ridiculous and too simple, but you’ll see with a few examples of how cutting back just a little and choosing to invest will set you up for the long run.
Introduction
This article is intended for anyone who thinks investing isn’t for them. That it is unreachable because they don’t have the money, the knowledge, the time, the whatever that prevents them from putting a bit of money away. In this article, I’ll show you some basic examples with some lovely charts and some buzzwords you may or may not know. My goal is to teach you that it doesn’t take much to be an investor. That through some delayed gratification, discipline, you can put yourself on a path towards homeownership.
Kevin Schmidt x Dall-E
I was interested in money from a young age, quite likely because we didn’t have much growing up, and I wanted to be self-sufficient and to put myself as far from poverty as I could. Finances are an interest of mine, and from discussion with younger people around me it seems many are dismayed and feeling uncertain if they’ll ever be able to afford a home with wages flat and inflation soaring. If you can relate, and you’re interested in real estate, then read on.
The Problem With Small Expenses
There actually isn’t a problem with small expenses. They can be necessary and enjoyable, providing momentary happiness and comfort in life. We’ve all been there (I’m writing this from a coffee shop in Vietnam). The issue through is that they add up over time, and can dramatically alter the course of one's life. Frequent, impulsive purchases can soon become habits which will end up draining a person's bank account, especially if they aren’t tracked in a budget. The dreaded and boring budget. Don’t worry, you don’t have to make one-though goal setting is supremely helpful if you want to get serious about making substantial changes in life.
Your Dollars Are Your Tiny Little Workers
An analogy I’ve found helpful and remind myself of often and find myself telling to others is to consider dollars to be your employees. These are your workers standing at the ready to be put to work for you. Just as workers earn income and profits for their employer by performing tasks, dollars can be put to work to generate income and increase wealth over time.
Let’s take, for example, a $5 coffee every day. This adds up to $1,825 in a year. That’s over 1,800 employees that would’ve otherwise been put to work for you, earning compound interest in a savings or investment account.
The “Rule of 72”
I was seventeen years old when I learned of this rule in a high school Junior Achievement class which focused on financial literacy. The Rule of 72 is a simple concept that estimates the time it takes an investment to double in value, given a fixed annual rate of return. Here are some examples below with the purpose to show the importance of both time and earned interest rate:
At 2% interest rate, it would take 36 years to double an initial investment (2 × 36 = 72)
At 4% interest rate, it would take 18 years to double an initial investment (4 × 18 = 72)
At 8% interest rate, it would take 9 years to double an initial investment (8 × 9 = 72)
I’ll stop at 8% because it’s quite difficult for the typical investor to perform better, but hopefully, you see the relationship of time (years in this case) and annual rate of return. Knowing time is a factor, an investor should start as young as they can. And the investor should seek the highest rate of return – though keep in mind that generally the higher the interest rate the higher the risk of losing money!
Compound Interest: A Snowball Rolling Down A Hill
Some of you may have heard of compound interest, to some this may be a new concept, and to some it might be something you’re familiar with, but it is still confusing. I’ll share with you an analogy and an example to firm up your understanding of this critical investing concept.
Whenever you hear of compound interest, think of a snowball rolling down a hill. Imagine forming a snowball in your hand, rolling it on the ground to gather more snow, and then letting it roll down a hill under its momentum as it begins to grow larger and larger over time. As the snow “earns” more snow, your interest earns more interest – exponentially!
There is a formula behind all of this, but I’m choosing to leave it out for now. Instead, let’s see some visuals of different snowballs in action rolling down hills that are somewhat flat (2% compound interest), a bit steeper (4% compound interest) and steeper still (8% compound interest).
Notice what a remarkable impact interest rate has? And also notice our Rule of 72 from above in action – it took 36 years for our initial investment of $1,825 to double!
Compounding Coffee
With some basics introduced, let’s see what some examples of how some discipline can put you in a position for a down payment on a property. In this case, let’s select an investor eighteen years old (the youngest one can be to open a brokerage account). Let’s assume they have varying levels of coffee addiction ranging from 1, 3, and 7 cups of coffee a week and that they have the goal to own their first home by the age of 33 – the average in the United States.
Some math to get us set up:
1 cup per week: 1 cup x $5 x 52 weeks = $260 per year
3 cups per week: 3 cups x $5 x 52 weeks = $780 per year
7 cups per week: 7 cups x $5 x 52 weeks = $1,820 per year
Let’s use 8% as our compound interest rate (the slope for our snowball), since this is the inflation adjusted return for the S&P500 over the last 30 years. Doing so yields the following:
Our example of 3 cups of coffee per week for 15 years yields an astonishing $21,179! But now what? How can that money possibly be used to buy a house? Well, to buy a home, a down payment is required to secure a loan from a bank. Sometimes people put down 20% or more on a down payment. The average though in the United States is around 6% down. Houses backed by FHA loans require only around 3.5% down! Here’s some simple math to see what value of a home someone can afford with our $21,179:
At 20% down, our cups of coffee can secure a home loan worth $105,895
At 6% down, our cups of coffee can secure a home worth $$352,983
At 3.5% down, our cups of coffee can secure a loan worth $$605,114
This is done simply dividing our down payment by the percent down on the home value. For our 3.5%: $21,179 / 0.035 = $605,114.
Final Thoughts
Small expenses can grow into giant snowballs. By choosing not to enjoy a couple of cups of coffee per week, a young investor can realistically by the time they are in their thirties afford a home worth over half a million dollars! Your dollars can be your workers if you decide, and if you are able. Compound interest is your friend, your steep slope to grow your snowball. And, from our rule of 72, time is the other factor with compound interest which ultimately will help you grow your wealth. And this isn’t just about coffee, because really all we’ve done is determined that by investing just $65 per month at 8% interest for 15 years to allows one to buy a home for over $600,000.
Next Steps
Learning to invest – we need to find a snowy hill for our snowball.