By Herbert Kyles, AWMA®
You’ve heard it over and over again: spend less, save more. It’s one of the most basic pieces of personal finance advice and for two very good reasons.
First, some things in life cost more than what you can make in a month. For example, when you buy a house, you need to make a down payment of at least 5%. You can’t do that if you spend everything you earn. Second, someday you won’t want to work anymore or you can’t due to age, illness, or some other factor. And if you stop earning an income, how will you pay for your living expenses?
You likely knew this already, but you may still find yourself spending rather than investing or saving. If that’s the case, you may want to look at what your spending habits are really costing you.
Say you just bought a new car. You took out a loan to pay for it and now you have a $400 per month car payment. You have at least $400 available in your budget each month, so you feel you can reasonably afford to pay that amount because you’re not living above your means. But how much does that car really cost you each month? The loan is debt, so you pay interest but that’s included in the monthly payment. Still, the answer is far more than just $400 because that only represents the sticker price. (For more, see: The True Cost of Owning a Car.)
It fails to account for the opportunity cost you pay when you spend instead of invest or save. You only have so much money to use, and an almost infinite amount of choices to make about what to do with that money. Opportunity cost is the loss you face when you make one choice over another, because you can’t do everything. In this case, the opportunity cost that occurs when you spend instead of invest is potentially massive. There’s no chance to earn a return on your money when you spend. But you could exponentially increase your wealth when you invest.
Let’s go back to that $400 per month you chose to spend on a car rather than save or invest that cash. That adds up to $4,800 per year, or $24,000 over a five-year loan term. When you reach the end of that five-year period, you’ll have a five-year old car worth exponentially less than what you paid for it and you’ll be out $24,000. Now, let’s assume you invested $400 per month for five years. Assuming a very conservative 5% rate of return, at the end of those years, you would have $27,033.54. In other words, you’d have a little over $3,000 more than you spent on the car.
Compounding Return on Investment
Compounding return on investment (ROI) makes spending more expensive because of the power of compounding returns. This can have an exponential effect on your nest egg over time. As you invest and earn a return on your initial contributions, those earnings can start earning a return on their own.
In your first few years, you may not see much of that exponential growt, but if you continue investing over 10 years, 20 years, even 30 years, you can see massive gains. This requires you stay invested over the long-term and clearly, it requires time. The more time you can give your money to stay in the market, the more likely you are to see the benefits of compounding in your portfolio. (For more, see: Investing 101: The Concept of Compounding.)
This is another big tradeoff you make when you spend instead of save. You rob yourself and your investments of the opportunity to let time do the work (rather than you working hard to try and make up for a savings shortfall later).
Striking a Balance
Before you head off thinking this only applies to big things like $400 car payments, consider this: yes, that daily latte really does add up. Let’s say you spend $8 per day to buy your lunch at work. Buying your lunch saves you time in the morning and it’s a great excuse to get out of the office every day. And it’s not like you’re going into debt just to buy that lunch; you’re not spending more than you make. You can afford that $8 per day, right? Maybe not when you consider after five years, you’ll have spent over $10,000 on your daily lunch habit.
If you brought your lunch from home, your cost per meal would probably be $4 or less. If you brown-bagged it and saved or invested the difference, that would be an additional $5,000 (or more) in the bank for you. That doesn’t mean you need to forever eliminate takeout lunches from your life, or start scrimping to the point of depriving yourself or missing out on great experiences today. Life isn’t all about saving for some distant tomorrow and you should use your money to enjoy yourself to a point.
There’s a balance you need to strike, because the tradeoffs go both ways. Throw everything into savings and investments and you risk becoming one of those sad stories of people who worked their whole lives trying to save - only to have their plan derailed by accident, illness, disability, or even death. But there’s also a real opportunity cost to throwing caution to the wind and spending everything you have in the moment. It’s not that you can’t spend, but it might be wise to spend mindfully and carefully consider if that little purchase or impulse buy is actually worthwhile to you. (For more from this author, see: Saving Isn't Enough, You Need to Invest Too.)
This article was originally published on Investopedia.