The Latte Factor is a bit of a buzzword in the personal finance industry. It’s clever because “latte” sounds a lot more engaging than “effects of compounding interest on accretive savings”.
But that’s the secret to why it works: personal finance is interesting when discussed in terms of daily life (and cures insomnia when discussed as a maths subject).
Here’s a non-complicated look at how it all works.
The Latte Factor is from personal finance writer David Bach, who explains that the foundation of wealth comes from paying attention to the small things (like a $5 latte).
Now this isn’t actually a new concept; you probably had a piggy bank as a child. The only twist is that we often underestimate how much of a difference the small savings make.
Here are some ways that saving small amounts impacts your personal finances, in a huge way:
Do you have friends who seem to be able to travel, indulge in fine dining, buy the latest gadgets, etc. despite earning the same (or even less) than you?It’s not always rich parents, or secret side-income. Most of the time, the secret lies in something called conscious spending. Here’s an example:
Say you’re given a choice between a slightly bigger portion at the mediocre office canteen, or going to that restaurant you keep reading awesome reviews about. Which would you prefer?
Your conscious mind probably picks the restaurant. Unfortunately, that’s not the part of your brain that’s often in charge of money.
Your unconscious mind often determines the bulk of your spending.
Let’s say, you were to pack sandwiches instead of eating at the frankly meh office canteen. If you saved $3 per meal, you’d have around $60 by the end of the month. You could afford to try a new fancy restaurant every month, just by giving up the canteen food you don’t really like anyway.
This is why people who master conscious spending lead more fulfilling lives. They can afford their holidays, yoga studios, the clothes they want, etc. because they’re careful not to sink money into lesser indulgences.
They bring their own coffee instead of buying it, they use the bus instead of Grab, they freeload by watching movies on Netflix, etc.
Saving like this doesn’t make them miserable at all because they’re trading in very trivial things, to buy things that truly fulfil them.
Think about that, the next time you’re about to casually upsize a meal or buy free moves on Candy Crush.
One problem with debt is that it forms a vicious cycle. For example, you may find that after paying off a large chunk of your personal loan or credit card, you’re left with very little money. When an emergency comes along, you’re forced to borrow again, hence undoing your repayments.
The best approach is to save even as you’re paying down your debt. And if you can’t set aside hundreds of dollars, you can start with just small amounts like $5 or $10 a day.
Over two to three months, these small savings are enough to tide you though emergencies such as having to replace a damaged laptop. As you don’t need to resort to loans, you’ll make real progress in getting out of debt.
By diligently doing this, you can work your way out of huge debts, which may be two to four times your monthly income.
Over long periods, such as 20 or 30 years, the effects of compounding can turn small savings into life-changing sums.
Remember that when compounding, the real interest rate (Effective Interest Rate, or EIR), is much higher than it seems. For example, if you were to earn a nominal compound interest rate of four per cent per annum, the EIR over a 20-year period would actually be around 119 per cent.
(You can see the actual maths here if you’re interested).
What you need to take away from this is that, if you save even a small amount more, the effect can be dramatic over time.
For example, if you save $200 a month at four per cent compound interest per annum, you’d have over $103,000 by the end of 25 years.
But what if you were to double your savings rate? Would you end up with ($103,000 x 2) $206,000 after 25 years?
Actually, you’d end up with close to $258,000, because of the power of compounding. Because the interest is building upon previous interest, you benefit disproportionately.
Even saving a little bit more, such as an extra $50 a month (about $1.70 per day) will give you around $129,000 instead of $103,000 at the end of 25 years. That’s a $26,000 difference for just $1.70 per day.
You can’t get it from a typical savings account. But you can grow your money at four per cent with simple, low-risk and passive investments.
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