A Million Dollars Richer – For Almost Nothing Except Coffee

Editor’s Note: A version of this post appeared in the San Antonio Express News

coffee_money
There’s my million dollars

I’d like to be a million dollars richer.

And I don’t particularly want to work for it.

I feel the way native San Antonian, former San Antonio Express-News writer and Saturday Night Live faux-philosopher Jack Handey did when he wrote:

“It’s easy to sit there and say you’d like to have more money. And I guess that’s what I like about it. It’s easy. Just sitting there, rocking back and forth, wanting that money.”

In the spirit of Jack Handey and his idle wish, I recently downloaded a budgeting app called Zeny.

Then, for one week only, I recorded my daily “indefensibles.”

Indefensibles, since you asked, are my own term for small consumption purchases that I did not have to make.

I don’t mean my kids’ after-school care, or the mortgage, or gas for the car. I don’t mean eating out with the family once in a while. I really mean things that are financially indefensible.

samuel_jackson_motherfucker
Yes, my barista actually made this Samuel Jackson latte and gave it to me. That’s how good a coffee customer I am. Which is scary.

Take my expensive coffee habit, for example. Because in my life, indefensibles come mostly in the form of caffeinated beverages.

I figure the cost of a cup of coffee, ground and brewed at home, averages about 15 cents.

Instead of grinding and brewing at home, however, I choose, day after day, to buy expensive coffee at more than ten times that price per cup. Well, actually, multiple cups. Plus, of course, a snack once in a while to accompany my fancy coffee.

And yes, since you asked, my “indefensibles“ concept is inspired by Warren Buffett’s pet name for his corporate jet. When you have Buffett money, a corporate jet qualifies as an indefensible, rather than the morning latte. Which is just one of the small ways my life’s financial path has diverged from Buffett’s.

Anyway, I downloaded the Zeny app on my phone to track my indefensibles for a week after reading the personal finance classic “The Automatic Millionaire” by David Bach. He famously coined the term “Latte Effect” to remind us that purchasing small daily items — a morning latte, for example — had massive implications for personal wealth creation (and destruction!) over the long run.

After reading his book, I became curious. How big is my Latte Effect?

Here’s my data from Zeny:

Day 1: $11.80

Day 2: $6.45

Day 3: $2.27

Day 4: $0

Day 5: $8.58

Day 6: $11.04

Day 7: $0.

All of these expenses I annotated in the app as either coffee or coffee-and-snack related.

My total indefensibles cost for the seven days: $40.14.

Does that seem like a lot of money? Check your own indefensibles against mine for a week. Gum and Tic-Tacs at the register. iPhone downloads. Hulu membership. That third beer for $3.50 at the bar. Whatever it is.

Over the course of a year, my $40.14 per week of indefensibles adds up to $2,087.28 (calculated as $40.14 multiplied by 52 weeks in the year).

What if I invested $2,087.28 every year for the next 40 years in the S&P 500, until age 82 — at which point it will be 2054 and I will be living on my hovercraft, being served hand and foot by my ageless Rihanna-bot?

rihanna_robot
This is what comes up when you Google ‘Rihanna Robot.’ Also, this is what 2054 will look like.

And what if that investment compounded at 10 percent per year? Then I’d have an investment pool worth $1,016,196.

What a coincidence! Because as I said in the beginning, I actually want to be a million dollars richer.

What? You don’t think 10 percent is a reasonable return assumption? Maybe not. Reasonable people can disagree.

But just so you know, the compound annual return from the S&P 500, assuming reinvestment of dividends, over the last 40 years was actually higher than 10 percent. Including the oil embargo years and stagflation of the late 1970s, the tech bubble bursting in 2000 and the Great Recession of 2008, the compound annual return including dividends from the S&P 500 was 11.7 percent.

If I achieved 11.7 percent compound annual return on investment over the next 40 years, my little pool of weekly indefensibles would grow to over $1.6 million.

Maybe you prefer I assume a more modest 6 percent future compound return? Fine, my indefensibles would only grow to $342,413.45.  Which, while not the same as a million dollars, isn’t nothing, either. $342K would place me squarely above the average American adult’s net worth.

From skipping premium coffee!

Let’s look at the calculation another way, however. What if I hadn’t ever gotten addicted to premium coffee outside the home in the first place? What if, instead, I had begun saving myself from indefensibles at age 22?

Even with a modest 6 percent compound annual return from the market, my indefensibles’ savings would grow to $1.1 million between age 22 and 82.

Deep_Thought_On_Money
A Deep Thought, by Jack Handey

So, I’m just curious — is there anyone else graduating from college this year who would like a million dollars without trying?

Look, every single person outside of the top 0.1 percent of wealth in this country struggles with one of two financial goals. Either you are:

1. Trying to reduce your personal debts, or you are

2. Trying to build up investments.

The same Latte Effect applies powerfully to both situations. Whichever goal you seek, you can decide to be a million dollars richer at the end of your life.

It’s easy. And that’s what I like about it. Just sitting there, rocking back and forth, not buying that latte.

 

Please see related posts:

Book Review of The Automatic Millionaire by David Bach

Wealth And The Power Of Compound Interest

Become a Money-Saving Jedi

 

 

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The Allowance Experiment, Completed!

bank of dadLast night completed Day 30 of the “Allowance Experiment,” in which I offered my eldest daughter a daily payment calculated as 10% of her allowance savings, compounding daily.  On day 1, she began with an initial grub stake of $1.  She received $0.10 on day 2 (10% of $1) and $0.11 on day 3 (10% of $1.10), and so on.

By Day 30, however, due to the magic of compounding, the daily payment grew to a substantial $1.44.  At the end of 30 days, she had $15.86 in the money jar.  That’s a pretty good sum for an 8 year old, because she can buy any ice cream her little heart desires, and $15.86 is also approximately 1/1000th of the way to obtaining an American Girl Doll.[1]

With this kind of experiment, one must stop after about a month.  Otherwise – because compound interest turns money into kudzu crossed with HGH crossed with a mutant Godzilla[2] – by 6 months of this I would end up paying her $2.1 million per day, and she would have over $25 million in her jar.  At which point obviously I’d be asking her for a daily allowance.

Plus with $25 million in the bank she could afford to purchase approximately 2 American Girl Dolls at the same time.[3]

Unexpected benefits

As I wrote before, one of the beneficial side effects of the allowance experiment – because I required her to do the daily interim calculations of 10%, plus adding up the totals in the jar – was appropriately difficult math for a 3rd grader.  This is smart parenting.

If her math errors worked in my favor, well that's just good banking practice
If her math errors worked in my favor, well that’s just good banking practice

You know what else is smart parenting?  When she messed up the calculations.  For example, when the 10% number she calculated ended up larger than it should have been, I immediately pointed out her error and asked her to try again.  I was not about to pay any more than I had to.

But what about when she messed up the calculations and it worked in my favor?  What about when she asked me to pay less in compound interest than I should?

Well, let me just say that all’s fair in love, war, banking, and parenting.  I mean, you can take the Dad out of Goldman Sachs, but you can’t expect to take Goldman Sachs out of the Dad, now can you?

Plus, as (my guide to all good parenting practices) Jack Handey points out, kids like to be tricked.[4]

The main point, accomplished

All jokes aside, the point of this experiment was not so much to induce savings or to teach basic math, but to viscerally illustrate the powerful force of compound interest.

I asked her if she understood the way in which money grew at an accelerating pace with regular 10% compounding.  She responded with a wide-eyed, “Yes, it gets really big.”

Good girl, my work is done here.

Please see related posts:

Daddy Can I have an Allowance?

The Allowance Experiment Gets Better

Daughter’s First Stock Investment

Book Review of Andrew Tobias’ The Only Investment Guide You’ll Ever Need

 


[1] That last number is just a price estimate based on gut feeling.  I haven’t looked it up.

[2] “Kudzu crossed with HGH crossed with a mutant Godzilla” is the name of my new favorite funk band.  Also, I’m going to copyright it as a title for my book on compound interest, so don’t even think of copying it.

[3] Again, all prices are just estimates.

[4] From the parenting guru himself: ‘One thing kids like is to be tricked.  For instance, I was going to take my little nephew to Disneyland, but instead I drove him to an old burned-out warehouse.  “Oh, no,” I said.   “Disneyland burned down.”  He cried and cried, but I think that deep down, he though it was a pretty good joke.  I started to drive over to the real Disneyland, but it was getting pretty late.’

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Daddy, I Need An Allowance

Daddy daughter shoes
Daddy, I Need An Allowance

Unintended Consequences

Parents will recognize the following as the “If You Give a Pig a Pancake” problem, referencing the ubiquitous children’s book about giving a pig the first thing (a pancake) which leads to the next thing (some syrup), which leads to the next thing (a napkin), and so on.

For those of you who have not been parents in the past twenty years and aren’t familiar with the pig-and-pancake problem, file this one under the “Department of Unintended Consequences” Tab.

Background to the problem

Readers may recall my wonderful, awful, idea a few weeks ago to introduce my eight year-old daughter to stock investing.

Fast forward a few weeks to a conversation she had with my Managing Editor (aka wife) last night.

“Mommy.  I need money.”

“Why?”

“There’s a book fair at school but Daddy took all of my money and put it in stocks.  And stocks are not fun at all.”

“I’m sorry dear.”

“Can I have an allowance?”

“Let me talk to Daddy.”

Ugh.  It is true that I took all of her money.  And converted it into shares of Kellogg stock.

And it’s also true that the steady stream of loose teeth – her main source of revenue via the Tooth Fairy – has dried up lately.  There’s just no telling when the next tooth will drop, and then the school book fair comes up.  Girls who don’t lose teeth don’t get paid.  And then she needs fairy princess dolls, then it’s just all like, bills, bills, bills for my eight year old right now.  You understand what I’m saying.

I didn’t hear about this conversation at first, but I noticed my oldest daughter kept prompting my wife to bring up some particular unnamed topic last night. 

My daughter was eager for the conversation, but my wife strongly preferred that she and I develop a common strategy with regard to allowances, without having to simultaneously negotiate with an eight year-old. 

(Here’s where I ought to insert some analogy between negotiating with 8 year-olds and negotiating with terrorists.  Or lately, negotiating with Congressmen overly responsive to hard-core constituencies, encouraged by a system gerrymandered for incumbency.  But I digress.)

Also, my wife assumed I’d have some strong ideas about what to do when it comes to kids’ finances.  You probably won’t believe this, but I have a lot of thoughts about allowances.

If you give a pig a pancake, pretty soon she'll ask for some syrup
If you give a pig a pancake, pretty soon she’ll ask for some syrup

Allowances!

So now we have moved, like the proverbial pig and his pancake, from the “first stock investment” phase to the “allowance phase” of parenthood.  At this point my wife and I haven’t fully decided what to do, although I’m about to explain to you my best ideas so far, at least for the first month of her allowance.[1]

This is one of the cleverest allowance ideas I’ve ever come across, so I thought I’d share before even rolling it out to my family.

Another Wonderful, Awful, idea.

I mentioned this other wonderful, awful, idea once before, buried at the end of a book review I wrote for the excellent The Only Investment Guide You’ll Ever Need, by Andrew Tobias.

You see, I’m always on the lookout for ways to show that compound interest is the most important and powerful math concept in the universe, and Tobias suggests the following children’s allowance plan for driving the idea home.

In fact he lists three great ways of teaching the power of compound interest to kids through the mechanism of the allowance.  Each one has its own special advantage.

Cookie Jar Experiments
Cookie Jar Experiments

The power of compound interest – The Cookie Jar Experiments

Tobias describes three versions of what he calls the Cookie Jar Experiment, which over a month or two can viscerally and intuitively teach the magic of compound interest to kids through the mechanism of an allowance. 

 Version One.  Offer your kid $1 on Day 1, and put it in a cookie jar.[2]  Offer to add 10% more each day, as ‘daily interest growth’ on that original $1. 

So, for example, on Day 2: $1.10 would be in the jar,

Day 3: $1.21.  And then on

Day 4: $1.33. 

After a month there will be a total of $17.45 in the jar, which shows how powerful 10% compounding can be, even if you begin with just $1. 

Tobias suggests you probably won’t continue the experiment to the end of Month 3 ($5,313) or Month 6 ($28 million) but really that’s up to you and your own resources. 

In my opinion, the power of compound interest as a concept is really worth teaching, so some of you will want to consider going the full 6 months.  It will only cost you $28 million in total.  If you do decide to do everything it takes to teach little Johnny the power of compound interest, be sure to email me at Bankers Anonymous so that I can provide my bank account number for the minimal 2% fee I normally charge for this kind of life-changing advice.

Anyway, back to my regularly scheduled commentary.  While ‘real life’ doesn’t let you compound at 10% on a daily basis,[3] the experiment lets you demonstrate the amazing power of compound growth to your kids in a concrete way.

The 1 month time period – by which $1 grows to $17.45 – is short enough that kids can see the growth and just how powerful it can be.

Version Two.  

This next version of the Cookie Jar Experiments is best for two kids, and it can drive home the power of compounding early, plus delayed gratification.[4]

Between your two kids, you offer a similar deal to version one, but with a twist.  If one of them is willing to skip the first three days of interest accrual, they can get something desirable like a chocolate bar.

After they finish fighting over the chocolate, you run the experiment for, say, two months.[5]  The child who went without the chocolate has $304, while the ‘lucky’ child who got the chocolate only has $228 in the cookie jar at the end of 60 days. 

The lesson: Start saving early because it’s the earliest accruing period that matters the most. 

The child with $304 can now buy a whole bunch of delicious cookies and leave the greedy chocolate eater weeping.

Are we having fun yet, kids? 

Kids?  Please stop fighting, please.  Thank you.

Version Three

“If only he’d used his powers for Good, instead of Evil.”

The final version of the cookie jar experiment allows you to compare for your kids the power of compound interest to create wealth to the power of compound interest to dig ditches of indebtedness via credit cards.

Run the same experiment as in Version One, but use the interest rate associated with many credit cards.  Let’s pick 20% because it’s a round number, even though many people’s effective credit card rates are even higher. 

Start adding money to the $1 at a 20% growth rate and label this ‘Credit Card’ growth.  On Day 19 the ‘credit card’ account has grown to $32, versus the $6 to which the original savings at 10% per day grew. 

If you run the comparison all the way to Day 35, the difference is $590 for the credit card account versus $28 for the ordinary 10% growth account.  The key to this version is pointing out that some people scrimp and save and achieve some growth on their savings, while others pay huge portions of their money to credit card companies.

Here’s a video version of this allowance experiment:

Again, of course, whether you fill up a cookie jar with $590 is up to you and your family’s means, but you can create an unforgettable demonstration for your kids of how small differences in compound interest rates make for giant differences in the medium and long run.

So what will we do about the allowance request?

So will we decide to run these experiments on our children when they request an allowance?

I’m going to push for at least Version One to kick off the new allowance phase for my eight year-old. 

She may not literally be having fun with the fact that all of her tooth fairy money is tied up in Kellogg stock right now, but I’m pretty sure it’s nothing years of therapy in her future can’t undo. 

If she complains, I’ve got a Jack Handey quote ready:

One thing kids like is to be tricked. For instance, I was going to take my little nephew to Disneyland, but instead I drove him to an old burned-out warehouse. “Oh, no,” I said. “Disneyland burned down.” He cried and cried, but I think that deep down, he thought it was a pretty good joke. I started to drive over to the real Disneyland, but it was getting pretty late.”  — Jack Handey

That’s why I say, deep down inside, she’s knows stock investing is fun.  And so are Daddy’s experiments with allowances.

Please see related posts:

Daughter’s First Stock Market Investment

The Allowance Experiment is even better than I expected

 Book Review of The Only Investment Guide You’ll Ever Need by Andrew Tobias.

 


[1] After that, we may revert to a more typical $2/week, conditional on a usually-left-undone chore – cleanup of the girls’ room – that drives my wife nearly to glue-huffing, out of frustration, on a weekly basis.

[2] Or, wherever.  Do cookie jars even exist anymore?

[3] Except, you know, if you’re a pay day lender.

[4] Also, it pits your children against one another, which is always fun.

[5] Again, adjust to your own means.  And then, of course, send me a reasonable fee if your means are extraordinarily large.

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Ask an Ex-Banker: Home Loans and Home Equity Lines of Credit

Q. Dear Banker, My wife and I are planning an addition to our house. We need the additional space, but I do not want this project to stretch our overall budget. Since I have a specific idea of how much I want to pay, a rise in interest rates would cause us to make different decisions on the project details. Unfortunately, we need to make those decisions now but will not need the money for another 8-12 months. I don’t care if interest rates go down, I like where they are now, but borrowing money before you need it sounds foolish. How does your average Main Streeter hedge against interest rate swings?

Bradley T., San Antonio TX

 A. I understand your question to be whether you should borrow money now, before you need it, because rates are ‘low enough,’ and because you worry rates will not be this low in another 9 months when you actually need the money for the home renovation.

My short answer is: “Maybe, although I personally would not” as to whether you should borrow now and lock in today’s low fixed rates, in anticipation of needing money 9 months from now.  I’ll explain what I mean by that in a moment.  The longer answer, which I’ll detail more fully below that, is that you really need a home equity line of credit, not a fixed-rate home equity loan.

The Short Answer                                      

Should you lock in a loan 9 months early because rates are ‘low enough?’  I’ll make a bunch of assumptions to be able to answer the question specifically, and I hope you can adjust the answer to your own particular situation.

I’ll assume you can get a Prime[1] rate home equity loan for a pretty major $100,000 home renovation at 5%.  That means you’ll pay $5,000 per year in interest, or an extra $3,700 for borrowing 9 months early.

$3,700 is not the end of the world for peace of mind, and so I’ll answer “maybe” borrow this way to lock in an attractive low rate like 5% today.

There are a few reasons, however, why I would not borrow money early myself.  Foremost, we really have no idea which way interest rates will go in the future.

As a former bond guy,[2] I pay quite a bit of attention to interest rates.  Had you asked me at almost any time in the last 10 years whether interest rates were likely to go higher or lower in the next 18 months, I would have said ‘higher’ approximately nine out of ten years, and I would have been wrong approximately nine out of ten years.  That’s not because I’m ill-informed, it’s just because it’s much harder to forecast the future direction of interest rates than it seems.

Because of my own deep uncertainty about the future direction of interest rates, I would argue your choice to borrow 9 months early ‘locks-in’ a loan interest ‘loss’ of $3,700, whereas the rate available to you has a 50-50 chance of being higher or lower 9 months from now.  If you accept my view, then your interest cost for the next 9 months, by not borrowing, is $0, which is much more attractive than losing a guaranteed $3,700.

But what if, 9 months from now, your fixed rate jumps to 7% from today’s 5%, and you’re locking in a 10 year $100,000 loan at $7,000 a year, rather than the more attractive $5,000 a year interest cost?  Well, in that case, if you carry the full sized loan for 10 years, you’ll pay a total of $20,000 more in interest over the life of the loan.  In that stark (probably-worst-case-scenario) example you will have lost out, and you will curse my advice, as well as my children’s children.[3]

Given that the starting position of borrowing early is that you’re $3,700 poorer, however, I see many more scenarios in which you come out ahead by not borrowing early.

If you plan to pay down the loan principal faster than 10 years, for example, or rates shoot up less than 2% over 9 months, or rates stay the same, or rates go down even further, you will have broken even or ended up better off by not borrowing early.  So that’s why I wouldn’t take today’s rates.

The Longer Answer

Instead of a home equity loan locking in today’s good fixed rates, what you actually need is a home equity line of credit (HELOC) from which you can borrow money and pay down at any time.[4],[5]

When I started a business in 2004, I met with an elderly entrepreneur who gave me great advice: Obtain the largest possible home equity line I could, not because I needed it now, but, because as an entrepreneur I needed to be ready to take advantage of opportunities whenever and wherever they might arise.

He was right.  In fact, any person who is both a home owner and a business owner, needs to stop everything right now and start applying for a home equity line of credit.  Why are you still reading this blog post?  Go, do it, now.  I’ll wait.

Ok good, you’re back.  You’re welcome.

In your case, Bradley, the potentially higher rates one year from now will be more than made up by the fact that you can borrow only the amount you need, as you need it, for your home renovation.  The slower drawdown of debt principal and the faster payoff of principal via a home equity line of credit is virtually certain to save you interest costs in the long run.

I believe the fact that HELOC rates are floating – they may go up or they may go down over time – are more than made up for by the variable amount of principal you can take out only as and when you need it.  Over the course of your planned home improvement project, if you borrow for example $33,000 for some period of time, rather than the full $100,000 loan, you’re obviously paying 1/3 of the interest costs than you would on the full amount, during the period of the smaller borrowing.  My point is that even if you end up with the same peak amount of borrowing, $100,000, you’re likely to have paid significantly less in interest in getting to that point.  Most of the time, those savings will outweigh the probability-weighted cost of higher future interest rates.

A special note for small business owners, new and old:  If you’re just starting out, the HELOC may be your only ticket to borrowing money cheaply and flexibly.  Banks only pretend to lend to small businesses, and they certainly do not lend to new small businesses, so it’s hardly worth trying that route.  Banks do lend, however, against houses and home equity, so you’ve got a shot there.

For experienced small business owners: You still need the largest home equity line of credit possible.  You never know when the commercial property right next to your office may become available, and when having $50,000 in ready cash is the difference between acquiring the real estate of your dreams and paying more to lease office space for the next 30 years.  If you have to go to your bank to apply to get the loan to buy the property next door, you’re too late.  You need the home equity line so that you can credibly represent to the sellers your ability to close the transaction within 1 week, in ‘cash.’  That is how the pros do it.[6]



[1][1] Meaning, you have excellent credit, at least above a 720 FICO.  The FICO people sell their scores from all three major credit rating agencies here for about $35.  It’s worth it to pull your score once in a while, so you can confirm you’re eligible for the best rates and there’s no weird activity on your credit reports.  Don’t let FICO trick you into paying $14/month.  That’s stupid.

[2] No, not the Daniel Craig type of Bond guy, much to my wife’s chagrin.

[3] Which is as good a segue as I can think of for repeating Jack Handey’s Deep Thought: “I believe in making the world safe for our children, but not our children’s children, because I don’t think children should be having sex.”

[4] This entire ‘Ask an Ex-Banker’ advice column today assumes you are a responsible borrower, and that debt incurred through a home equity line of credit will go toward productive home and business improvements and not be blown on subsidizing your unsustainable consumer-driven lifestyle.  In your case, Bradley, since you live in San Antonio, that means you can’t blow the whole line of credit on Alamo Lego miniatures and bad Tex-Mex food.   But since www.bankers-anonymous.com readers are, almost by definition, extremely responsible with debt, this hardly bears mentioning.

[5] Most HELOCs give you a drawdown period of, say, 10 years, followed by a payback period of another 10 or 20 years.

[6] While I’m very much in favor of HELOCs for small business owners, I need to acknowledge in the fine print here that things can and have gone wrong for small business owners putting their houses at risk.  Of course this would be terrible.  When you get a HELOC for your small business, make sure you save it for an opportunistic can’t lose situation, not use it to keep your flailing, unsustainable, small business alive.

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