First off, a little recap of investing and how that works. You save money, you buy investments, and over time those investments go up in value and pay you interest/dividends. It’s really that simple. The only reason you would lose money is:
Other than those two reasons, you should be investing (as we mention here) at least 30% of every paycheck, which includes your 401k and IRA contributions. Trust us, do this and watch the balance grow over time. You can visit my last article for a guide on how to get started investing if you haven’t already. However, if you make money, you have no excuse. Remember, the average annual performance of the stock market over hundreds of years has been ~7% after accounting for inflation and taxes. This takes into account the recent volatility that we have seen due to global pandemics, as well as the 2008 financial crisis.
Use the stock markets compounding growth to your advantage, just like the Millionaires in Tom Stanley's best selling book, The Millionaire Next Door: The Surprising Secrets of America's Wealthy.
Read More: Introduction to the Stock Market
If you do the math, $100,000 invested at 7% for 2 years would be $114,490 ((100,000 * 1.07)*1.07). Notice how that number isn’t 114,000 even. That’s because in the second year, your return of 7% is calculated on the $107,000 that your account would be worth after the first year. This magical phenomenon is called compound interest (where your previously earned interest makes you more interest) and literally will change your life.
One important thing to note is that Humans are generally TERRIBLE at estimating compound growth. For example, try to estimate how much the aforementioned 100 grand would grow to if it compounded at 7% annually for 50 years instead of just 2 years. You probably didn’t think it would reach almost three million dollars. Remember:
When investing, this year and next year don’t matter much. It is the long term patience and time in the market that will pay you the most. Einstein once said that compound interest is the eighth wonder of the world; Those who understand it collect it, and those who don’t understand it pay it. (In the form of interest on loans, credit cards, etc.)
I’ll finally get to the point of this post.
With compound interest in mind, it is easy to see how a seemingly normal expense like a car payment (US Average of $499/mo before insurance, gas, tolls etc.) can add up to literally millions of dollars over the course of your life. Even if you have a “cheap” car (say, $200/mo) it is COSTING you the ability to invest that money for the length of your lease. In economics, we call this the “opportunity cost” because it is costing you an opportunity. Economists are not known for their creativity.
So the opportunity cost that you are giving up by choosing a $200 car payment is having $1,000,000 in 50 years. This is just from one very average car payment over your life. If you add in the affiliated expenses or a more expensive car you can calculate how ludicrous the numbers get. Use this compound interest calculator to help you. When using the calculator:
Current Principle: $0
Annual Additions: (Car Payment)*12
Years to Grow: 50
Interest Rate: 7%
Total Balance After 50 Years: $1,043,966
If you calculate that your car is costing you $500 total each month (about the average), you are losing the opportunity cost to have $2.5+ million dollars in 50 years. After explaining how this math works, the light bulb goes off for most people and they realize how ridiculously expensive having a car on monthly payments is.
The MOST cost effective way to have a car is to buy a used vehicle outright. Some great deals can be had on a car that is 2-3 years old with low mileage because somebody else leased it and already paid for the depreciation. This is how we recommend you buy your cars unless you are a multi-millionaire.
Cars usually depreciate most in the first 3 years of driving, so whoever leased it first paid for all of the depreciation for you. Thanks generous stranger!
One common question I see posted online is the difference between a car lease and car financing. Both of these options come with monthly payments, which we do not recommend. Here is a quick and dirty breakdown for you:
Read More: What is Leverage?
You shouldn't have a monthly car payment, so when you’re looking to buy your used car make sure it is something you can afford. If you own your car outright, it also allows you to get a low cost insurance plan because we don’t owe anyone any money on the vehicle.
Combine this with a close proximity to work and maybe a bicycle (Like Mr Money Mustache Recommends) for getting around closer distances, and I’m sure that most people can get from paying $499+/mo to less than $200 including all expenses. It would be unrealistic to think that we can cut all of our car related expenses out, but minimizing them this way is the best most of us can do. And now you can calculate how much you’re saving yourself! Woo!
I hope that this quick blog post into opportunity cost and compound interest opened your eyes to how seemingly harmless decisions affect your financial future. Will you be a more conscious spender when it comes to all of your monthly expenses? Let us know by dropping a comment / DM on instagram or YouTube
If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!
P.S. New blog posts coming your way every Monday!
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