Years ago, David Bach hit it big with his concept of the “Latte Factor.” According to his website, the Latte Factor concept is based on focusing on small expenses in order to save money for retirement and other goals. In theory, by eliminating those $5 and $10 recurring expenses, you can have the money available to save for your long-term goals. He was able to turn this concept into a nice little empire, writing books and even showing up on Oprah a few times. The best example he used was spending $5 on a daily latte at the coffee shop in the morning – hence the name.
One of the reasons the Latte Factor and other small expense focus ideas became so popular is because it’s easy for anyone to do. It’s easy to go through your credit card statement, find these small charges, and focus on cutting them out of your life. It’s hard to figure out ways to earn more money, to move to a smaller or cheaper house because your housing expenses are out of whack with your income, or to deal with the cost of children. Unfortunately, these small cuts are often unsustainable in the long run because these are often the little things that people enjoy the most. My officemates and I run to the coffee shop together a few times a week and it’s something we all enjoy. You get the comradery with your coworkers and a nice fancy coffee drink to boot. Who wants to get rid of that to save a few bucks each week?
The Financial Independence community needs to stop focusing on the small stuff. Instead, let’s focus on the big issues that really impact our financial lives.
This blog harps on the concept of earning more income to further your financial independence. Earning an above-average income is the most effective way to build wealth. The process of converting active income into passive income and passive income into F-You money is what leads to an amazing life. According to Ramit Sethi, millionaire households invest at least 20% of their household income each year. In order to get to being a millionaire or multi-millionaire in the first place, you have to save and invest even more than that. What’s the most effective way to invest 20%, 30%, 50% or more of your household income each month? Earn more money! Saving and investing 20% of your household income when your household income is only $50,000 is really difficult. Doing so at a $300,000 level just doesn’t reduce your lifestyle that much. Even saving 50% when you’re at a $300,000 level is fairly painless.
Earning an above average income isn’t difficult to know how to do, but it is very difficult to accomplish in practice. First, make sure that you learn a skill that’s actually valued in the marketplace. Art history or English literature may be your passion, but no one is going to pay you very much for it. I’m well aware that working in investments does little to benefit society at large. Yet the labor marketplace pays handsomely for it – something I knew before going into the field. Second, work your butt off, especially when you’re young and just starting out. Working 60 or 80 hour weeks is not only easier when you’re young (energy and a lack of commitments helps a lot), but it’s also the best time to do it. Hard workers move up the ladder faster and build reputations that help them down the road. Third, invest in yourself by furthering your education and making your skills more desirable in the marketplace. Again, be smart, as something like a CFA (Chartered Financial Analyst for investment professionals) or a CPA may be a better investment than an MBA at a fraction of the cost. Once you’re in your career, further specialization and licensing can pay off. Finally, network like crazy and try something entrepreneurial on the side. Networking will help keep you in the loop for better and more lucrative opportunities and an entrepreneurial side gig can earn extra income and even potentially replace your day job someday.
Only after working to maximize your income is it time to look at your expenses. The smartest move on the expense side is to minimize most people’s largest expense – housing. The average cost of housing in the US is over $1,600 per month. That number is likely low for many, as most large metropolitan areas have numbers far higher than that. In Chicago, that number is over $2,000. Boston is over $2,500, Los Angeles is nearly $3,000 and New York City is over $5,000. For someone making $75,000 in the Boston area, housing takes up over 50% of your take-home pay. How are you supposed to save 20% or more with a single expense eating up more than half your income?
Young people have the advantage here. The advice about living like a broke college student for as long as possible is good to follow. It’s okay to live in a small, crappy apartment when you’re 26. It’s not okay to do so when you’re 36 with a spouse and children. For those beyond their 20s and not living in crazy real estate markets like NYC and SF, controlling housing expenses really comes down to controlling your urges when you buy a home. The best play to make is to buy or rent way less home than you need, each time you do so. Buy way less home for your starter home, buy way less home when you upgrade, and buy way less home when you eventually downsize. A smaller and cheaper home has fewer out of pocket expenses, from a down payment and mortgage payment to property taxes, insurance, and utilities. We could discuss things like refinancing your mortgage and challenging your property tax bill, but each of those pales in comparison to buying less house than you need.
Housing is particularly difficult for many people because it’s both emotional and hard to change once you’ve made a decision. It’s emotional because our home is our castle and we want it to be nice and to be safe, particularly when kids come into the picture. This urge must be resisted, because our ideas of nice and safe often get highly enlarged when shopping for a home. Housing is also very difficult to adjust once you’ve made a commitment. Most leases for rentals are for at least one year and transaction costs when buying and selling are high. Plus moving is a real pain in the butt. Yet if you’re going to make a change, you often just have to bite the bullet and then live with that choice.
I’m not a car guy at all, so for me a vehicle is just a way to get from A to B. I don’t want a complete junker, but a nice lower to mid range sedan is just fine. Much to no one’s surprise, the advice here is similar to housing. Buy way less car than you can afford. You may be able to afford a Mercedes C-Class, but at $40,000-$50,000, there are far better ways to spend your money. Not only can cars be way too costly upfront, but ongoing costs are proportional to purchase price. Insurance and taxes are more expensive for pricier cars as well and any repair bill you get on your Mercedes will be inflated compared to a Nissan or Toyota.
We all want the best for our children, but they sure can be expensive. The two most directly related expenses to children are childcare and college, although you could make an argument that housing is tied to children as well. We’ve tackled the housing question, so let’s focus on childcare and college.
Childcare is a tough one because until the kids go to school, it’s a huge expense. My wife stays at home so our childcare costs are either zero or ridiculously expensive (lost income), depending on your point of view. The best way to minimize childcare cost is to compare several options and make decisions regarding trade-offs. In-home daycare is often much cheaper than centers, but with less flexibility and less professionalism. Centers give you the benefit of a larger staff and better facilities. Finding the right employer can help as well, either due to subsidized daycare or as a way to adjust schedules in order to minimize the amount of time your child spends in daycare. Another alternative for those lucky enough is to have a relative watch your children.
College for their children is the biggest looming expense for many professionals in the latter halves of their careers. Remember that you do not have to pay for your child’s college education. While I consider college education to be the bare minimum for kids to even have a chance at a middle class or above lifestyle, too many parents go into too much debt in order to send their children to university. Your kids will have a growing career to help pay down debt – you won’t. Beyond that, scholarships and community college are two great avenues to minimizing costs. Your child’s senior year of high school should come with a part-time job of applying for as many scholarships as possible. They’re abundant and many smaller ones are so under the radar that few people apply. Spending two years at a community college, with credits that transfer to a bigger name school, can substantially reduce the cost of higher education. Even better, if your child is advanced enough, they can take a few college classes while in high school. Many high schools have programs that allow you to earn college credits while fulfilling high school requirements at a far cheaper price per credit than while in college.
Some debt is okay, but most is stupid and wasteful. Reasonable amounts of student loans or mortgage debt can be a solid investment and are priced at reasonable interest rates. Better yet, debt supported by a cash-flowing investment such as commercial real estate can help build substantial wealth if done well. Beyond that, debt is a waste of money. Consumer debt, auto loans, and other unsecured personal debt are all expensive and unnecessary. If you’re in debt, stop reading this blog, go get a second job, and pay it off.
Bad financial advice creates some of the most expensive costs to building wealth. Financial advisors can be expensive in their own right, with many charging 1-2% or more of your assets each year. Commission-based financial advisors are even worse, stuffing you in investments that may charge 5% upfront just for the “privilege” of investing. Yet it’s not the explicit costs that are the most expensive.
Bad financial advice can cost far more than just the 1-2% of your assets each year. A bad asset allocation, excessive trading, and products like variable annuities that only enrich the advisor can cost you thousands upon thousands of dollars. Here’s what most financial advisors are unwilling to tell you: Most people do not need a financial advisor. Following an asset allocation approach like the Peace of Mind Portfolio, a 60/40 stock bond portfolio for conservative investors, or an 80/20 stock bond portfolio for most aggressive investors is all that’s really needed. When you become truly wealthy and need help with a more personalized asset allocation, private investments, structuring, and estate planning, it then makes sense to go to a high-end financial advisor that may actually pay for themselves. Until then, stay away.
Stop Playing Small Ball
Advice about reducing small expenses is a waste of time for most. Don’t worry too much about your morning latte or the occasional lunch out. Doing so just takes time and mental energy away from the things that can actually be really impactful to your financial life. Earning a higher income is the biggest of these. Nothing is as impactful as earning more money. It makes it easier to save a large amount of money each month, even when enjoying your daily coffee.
From there, move on to your big ticket expenses before worrying about the small stuff. Housing, cars, kids, and debt are all the biggest in-your-face expenses. Show restraint and always buy less than you can afford. The carrying costs on these can really add up over time. From a wealth-building perspective, nothing is as dangerous and costly as a financial advisor. Most people don’t need one and can instead follow a simple and straightforward investment plan.
Keep building my friends.