The Compound Effect of Our Life Decisions

A few life choices can make the difference of half a million in a decade or so.

Most of us have seen diagrams that show the effects compound growth can have on an investment over a number of years.  With a long enough timespan and a sufficiently high interest rate, the graphs are impressive.  You know, like if you invest $100 each month, and you average 10% growth, you will have a quarter of a million dollars saved up in 30 years.  

Now graphs like these look great, and mathematically they work, but the problem with them is we have to make the right decisions every month in order to have the money to invest.  So for the equation to work out nice and pretty like the graph, we have to make the choices that will leave us with the leftover cash every month to invest.  In this post we will look at a couple of life choices that will make the difference of significantly more than $100/month.

Compound growth works as a basic math equation, but it’s at play with our life choices as well. For example, if I start each day with a donut, by the time those 30 years we talked about pass by, I will have consumed 2.2 million calories!  Boy that is a tasty life!  But the simple cost of the donuts will be compounded by the monthly gym fees, bigger pairs of pants, and high cholesterol medications my doctor tells me to buy.

Before we look at more common, less tasty examples of how our financial choices have compound financial effects, let’s look at the three choices we have when it comes to spending:

1. We can borrow from the future to spend now.  This will make us poorer and poorer over time.  This will lead to an incredibly stressful life, and cause us to be complete slaves to our jobs.  Compound growth of your debt is at play here, and will lead to certain disaster.  
2. We can spend all of our money we earn.  At this rate we are just as broke after working for 30 years as we were when we were just starting out.  Job loss with this lifestyle would be a scary occurrence.
3. We can spend less than we earn, and invest the difference.  This is going to create a compounding growth of our wealth which will give us freedom to live life how we see fit.

Because time is an important part of the compounding equation, the earlier in your life you make expensive choices, the greater the negative impact.  Conversely, the younger you are when you make smart financial decisions, the greater the positive impact will be over your lifetime.

Let’s look at the compounding effects of two major life expenses.  First, transportation.  Our options are buying  new or used, and big or small. We obviously think about the upfront price differences, but just like the donuts, there are more costs than what first meets the eye.

Comparing a five year old Ford Focus and a brand new Ford Explorer, we find that, over the course of five years, you will spend at least $20,000 more going with the Explorer instead of the Focus.  What are the compounding effects at play here?  Well, obviously you suffer from greater depreciation with a newer car.  You also pay more on insurance and taxes for a newer, more expensive vehicle.  You are more likely to take out a loan for a new car, which puts you deeper in the “spending tomorrow’s money” hole.  As far as the vehicle’s size, you end up paying more in fuel and maintenance for a bigger car.  Think bigger tires, bigger parts, etc.

Now I know some of you are saying, “But, how will be able to fit all of my stuff into the car?  Also, I wanted to buy a boat for our annual trip to the lake, how will I tow that?”  I promise you, 98% of the time or more, you won’t need what the SUV provides.  I also promise you, even though you use the SUV capabilities 2% of the time you own it, you are paying extra for those luxuries 100% of the time you own it. (Obviously a small car isn’t always going to cut it for those of you with bunches of kids, so don’t write me angry comments. Just buy the used minivan and call it good.)

The other major life choice I want to cover is housing. As you have probably noticed, the trend in the past 70 years has been the bigger the better.  This, combined with significantly smaller families, has led to the average American “requiring” about six times as much indoor living space per person as was typically used two generations ago.  It has also led to significantly higher than necessary housing costs.  Sure we now have extra family rooms, workout rooms, and entertainment rooms.  Unfortunately, we don’t have any time to utilize them because of the second job we took to pay for our overinflated lifestyles.  

For you spreadsheet nerds, I have created this comparison of the true costs (Excel spreadsheet) of owning a 1,000 sq ft  $200,000 house with a 3,000 sq ft $400,000 version.  The calculations are based on 13 years which is the average time we spend in an owner-occupied home.  In addition to increased costs for mortgage interest with the more expensive home, you end up paying more in taxes, insurance, utilities, maintenance, upkeep etc.  Accounting for opportunity cost–what you could be doing with your money instead of putting it into your house– the difference comes to about $480,000 over 13 years.  

In addition to that huge sum, there are incalculable other costs that would likely come from a more expensive house. Pressures to fit in with our peers are strong, and it will be much harder to resist the pressures to drive nice cars, host fancy birthday parties, meet at expensive restaurants, wear trendy clothes, etc. when living in a higher cost neighborhood.

To review:

You can spend about $333 less each month by going with the smaller, used car. ($20,000/60 months)

You are spending almost $1,500 less each month by going with the smaller house.

You have $40,000 more to invest upfront by going with the smaller house.

Let’s take the difference from these examples and invest it.  Doing the math with a conservative return of 7% per year, we find that the compounding effects of these two life expenses can make the difference of about $564,000 in 13 years.  Seems tempting doesn’t it?  

To summarize:  Buy a smaller house and a smaller car, invest the difference, and you will have about half a million bones in a dozen years.

I used Edmunds True Cost to Own for the car calculation.   I actually think they over estimate the cost of the older car for most people because they assume you will be keeping full coverage on the car, and they also assume you will be financing its purchase.  Personally, I believe five years is too new for a car purchase.  I believe the sweet spot for best value is purchasing a car somewhere between five and ten years old.  At this point, the majority of the depreciation has already taken place, but reliability isn’t yet too much of an issue.

I was generous to the big spender in these examples and used conservative numbers for costs.  I also was conservative with the investment assumptions.  In other words, this is not an idealistic outcome.  I expect you to be able to beat these numbers.  Please do and report back in 13 years.