As you begin to understand what your life costs, the opportunity costs and what you truly value, you will likely begin to evaluate your spending differently. You will no longer see a purchase, especially large purchases, as solely a financial decision. You begin to evaluate these decisions in terms of your time. There is the actual time required to pay for something (i.e. earned income required to physically pay for it) as well as the opportunity cost of the purchase (i.e. forgone investment income). As a HENRY, you can likely afford most anything you want. However, you cannot afford everything you want. As you gain a better understanding of what your life costs, you should hopefully start to see areas where your spending does not align with your values. The secret is identifying those areas, understanding what you are sacrificing and taking action. Taking action includes understanding and leveraging investment growth and compound interest.
The Impact of Compound Interest in Your Life
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t pays it.” – Albert Einstein
Einstein was definitely on to something with the quote above. As a HENRY, I am sure you have a basic understanding of compound interest. When saving and investing, interest is derived from the principal as well as the accumulated interest from previous periods. Conversely, when you choose to take on debt, specifically high interest consumer debt, you are making a conscious decision to have compound interest work against your rather than for you. Most people understand this but often fail to see how daily decisions impact your long term ability to build wealth. Your financial life is a series of purchasing decisions which, when considered in isolation, may seem to have no real impact on the arc of your life or eventual outcome. However, financial independence and the FIRE movement has taught me that these decisions, when considered in aggregate, do in fact have a real impact. Every dollar spent is a dollar not invested. Every dollar not invested is a dollar that will not compound. Every dollar that does not have the opportunity to compound is a dollar not working for you. The key is understanding this and leveraging it.
My Lesson in Opportunity Cost: The True Value of a Car
As a HENRY, I am not immune to society’s pressure to drive a nice car. In fact, as a HENRY, I would argue I am more pressured in this area than the average person. My above average income affords me the luxury of buying brand new cars. One could argue that my above average income sets the expectation that I not only purchase and drive a new car, but a luxury brand. Something that is representative of my hard work and success. The decision to buy a new car and/or a luxury brand and other similar decisions slowly continue to compound which in turn transforms me from a high earner with the potential to be rich to a high earner that is not rich and will never be rich. I am at the mercy of my lifestyle. As my income grows, so too does my expenses.
For many HENRYs including myself, society has conditioned us to believe cars are one of the best measures of success. After all, what better, more visible measuring stick of wealth is there? What other asset is seen by everyone you work with, everyone living in your neighborhood and everyone you encounter when traveling to family engagements, vacations, etc.? Think about it… There is a reason cars are much more than just a utility purchase to get from Point A to Point B. They are perceived as an outward facing sign of how successful you are in life. The nicer the car you drive, the higher your income must be and the more money you must have. In some instances, this is true. However, for a lot of people including HENRYs, cars are often financed by debt. As a result, they don’t really outright own the car. As soon as they do, they upgrade and start the cycle over.
Several years ago as I was just discovering financial independence, I was also in the market for a new car. Specifically, I was in the market for a mid-size sedan and I narrowed my choices down to two cars. Option 1 was the well-rounded, popular and reliable Toyota Camry. Option 2 was the more expensive, luxurious and sexy Audi A6. The Audi was the car I wanted. It was the car I thought I deserved. The difference in price between the base models ($25K vs $55K) was ~ $30,000. Prior to discovering financial independence, I would not have considered the opportunity costs associated with the purchase. I most definitely would not have considered the opportunity costs of my time. However, that was then and this was now. I evaluated the purchase from a different perspective, through a different lens. I set out to answer the following questions when considering which car to purchase.
What would that $30,000 mean to me in 10 years, 20 years and 30 years? What was the financial opportunity cost? What was my life opportunity cost?
The answer surprised me.
Assuming a 10% return (which is the average historic stock market return before inflation), the $30,000 savings would grow to $77,812 in 10 years. Prior to discovering financial independence and the true opportunity cost of my life, I would have said $77,812 over 10 years was well worth it to have the Audi. I would have rationalized that as a HENRY, I could not only afford the car but I deserved the car. I work hard, make a good income and I want to be able to enjoy the fruits of my labor. I want people to know I work hard and that I am successful. Sound familiar?
I then ran the calculation to determine the 20 year and 30 year return. In 20 years, the $30,000 savings would grow to $201,825.00. In 30 years, it would grow to $523,482.07. That is when it hit me. The opportunity cost associated with my decision to buy or not buy the luxury brand equated to more than a half a million dollars over 30 years. A half a million dollars!
After the initial shock wore off, I started thinking. This example was not even accounting for the reality of what I knew would happen. What HENRY do you think is going to buy an Audi A6 and drive it for more than 10 years? Not this guy… After 10 years (or sooner), I would definitely be trading it in for the newer model. So I decided to run the numbers again.
With a quick internet search, I determined the average value of a 10 year old Camry is ~ $3,700. A 10 year old Audi is worth slightly more at ~ $4,700. Factoring in trade-in value, if I chose to forgo the Audi again, it would save an additional ~ $29,000 when compared to the Camry.
As noted previously, I would have ~ $77,812 invested at year 10 from my original decision to forgo the first Audi. When adding the ~ $29,000 savings to the $77,812 I would have a total of $106,812 at the end of year 10. What would the decision to forgo the Audi twice mean to me 20 years from the original purchase decision? Again assuming a 10% return, my original $30,000 investment in conjunction with my subsequent $29,000 investment at year 10 would grow to $277,043 at year 20. By choosing to forgo the Audi and the subsequent upgrade at year 10, I was $277K richer.
If I assume an additional upgrade at year 20, I would add the ~ $29,000 savings to the $277,043 for a total of $306,043 at the end of year 20. What would the decision to forgo the Audi three times mean to me 30 years from the original purchase decision? Let me spoil the surprise for you. A LOT!
The decision to forgo purchasing the Audi ($30,000) and the two subsequent upgrades ($29,000 x 2), would result in a savings of $793,798. Let me say that a different way. The opportunity cost associated with my decision to buy or not buy the Audi was almost $800K over 30 years. $800K! At the time, I understood the basics of saving, investing and compound interest, but this made it real. It made it tangible. The chart below gives you a visual of the growth ($705,798) as well as the contributions ($88,000 in total).
Once I understood the financial opportunity cost, I began to correlate it back to the opportunity cost of my time, my life. I began to again consider my current savings rate and my current financial trajectory. Using figures similar to those outlined in the chart below from my previous post, I contemplated the decision. I evaluated not only the immediate impact but also the ripple effect of the lost investment income and subsequent upgrades to maintain the purchase. The decision to purchase the Audi would result in me giving up years of my life just from the one purchase. A purchase that I came to realize I didn’t value as much as my time. The difference between a 15% and a 40% savings rate suddenly seemed more achievable.
The exercise was enlightening. Here, I was trying to determine how to increase my savings, how to speed up my path to financial independence, how to take back my time and my life while still maintaining the lifestyle I wanted. The answer was right in front of me. I simply needed to align my spending with my values and what makes me happy. I needed to understand what I was sacrificing. I now had a tangible answer. Did I value driving a luxury brand enough to forgo $300K+ over 20 years or $793K+ over 30 years? I bet you can figure out my answer. I was never the same again.
Another Inflection Point
The example above is exactly that. It is only an example: my example. If you enjoy cars, you can insert brands and models that make it real for you. If you enjoy your country club membership, but only play tennis or golf twice a month, you too can determine the opportunity cost of the membership vs. a more cost effective alternative. You can perform this exercise with any purchasing decision. The point of the exercise is to understand that each and every purchase you make has a financial opportunity cost. That financial opportunity cost then equates to your time. Your time is your life. That is why it is imperative your values align with your spending.
If you understand the opportunity costs and value something because it brings true happiness to your life, then you should buy it. As a HENRY you can buy lots of things, and you should if it makes you happy. I most certainly do. The key is identifying expenses or purchases that do not bring you additional happiness so that you can save and invest instead which allows you to take advantage of the 8th wonder of the world. This will allow you to boost your savings rate which is the key to going from the working rich to financially independent. This is the key to going from a HENRY to FIRE. So ask yourself, is it worth it? If not, you know what to do.
Note: I understand that my example assumes a 10% rate of return. I also understand that it assumes I invest the cash savings at year 1, year 10 and year 20 respectively. However, it also assumes I paid cash for the car instead of financing it which would cost additional money in interest that could have also been invested over the same time period. As noted above, it was only an example to demonstrate the opportunity cost of the purchase.
How to Calculate the Future Value of Money
There are many formulas to calculate the time value of money but today I wanted to provide the formula for determining the future value of money since this can be a key tool to determining opportunity cost. You can also utilize any online compound interest calculator to determine the future value of an investment or savings. I frequently use this Compound Interest Calculator to calculate the future value of money when I am making purchasing decisions. For those spreadsheet ninjas out there like myself, you can run your own calculation utilizing the future value formula below.
FV = (RATE,NPER,PMT,PV,TYPE)
FV = Future Value of Money
RATE = Interest Rate
NPER = Number of Periods
PMT = Payment Made
PV = Present Value of Money
TYPE = When Payment is Due (0 is beginning of month and 1 is end of month)
The ability to calculate and understand compound interest as it relates to your purchasing decisions is a critical component to understanding your opportunity costs and taking back your time and subsequently your life.
Regards,
– HENRY