Episode #42: My Unpopular Opinion: Why The Latte Factor Works (If You Want To Be A Millionaire)
As millennials I’m sure we’re all collectively pretty tired of being made fun of for our money woes. Comments from older generations about our money management capabilities can be tiring at best, and usually toe the line towards being patronizing and condescending. We’re constantly being hit with insulting quippy phrases like ‘stop buying avocado toast’, or ‘you should expect to work 2-3 years at an unpaid internship before ever expecting to be paid’, or being told that the reason we can’t afford homes in this overpriced market is because we buy too many lattes.
And this is where my unpopular opinion of the day comes in, because I actually agree with the theory known as ‘the latte factor’. I don’t agree that if we stop buying lattes we’ll suddenly be able to scrounge together an $80,000.00 down payment for a tear-down house, we’ve got a bigger fish to fry if we want to tackle that issue, but I do agree with the underlying theory of the latte factor. So if you’re currently feeling worried that maybe I’m going to start blaming your still living with your parents on your avocado toast addiction, then just do me a favour and stick around for a few more minutes while I explain what the latte factor is, what it actually means, and how you can use it in your life for good and not evil.
What is The Latte Factor?
The latte factor is a term coined by financial educator and author David Bach. And I’m gong to poke a little fun here but first let it be known that I’m actually a big fan of his books. He writes about a lot of classic personal finance theory that’s timeless and helpful, and I highly recommend a lot of his books. But when the latte factor comes up in a few of his books and he always tells it as the story of how he teaches in-person finance classes to corporate groups, and invariably someone scoffs at his lesson and says ‘it’s great that you’re telling me how important it is to save money, but I can’t even save $5.00 at the end of the month, let alone start a retirement savings account’. And he says ‘I’m willing to bet that if we walk through your habits I can help you save $5.00 a day, instead of $5.00 a month’. And the person takes that bet and protests that their budget is already bare bones as it is, and he proceeds to walk them through a public inquiry of their spending habits and finds things that they can cut out of their budget every day, namely a coffee and a muffin, that will help them save that $5.00 a day.
He then goes on to explain how by not buying this coffee and muffin, this person can save $5.00 a day, which adds up to $150.00 a month, which adds up to $1,800.00 a year which can instead be put towards starting to fund their retirement account which they previously swore they couldn’t find any money to save for. The money in this account will then be invested and compound at an average rate of return of 10% for 40 years, coming to a mind blowing total of $948,611.94. So, he demonstrates how saving that $5.00 purchase a day has the power to become almost one million dollars by the time that person retires. So this is what the latte factor is, but what does it really mean?
What The Latte Factor Means
What we can learn from the latte factor is how being mindful of the small daily purchases we make can help save us large amounts of money over time. Most people don’t blow past their budgets with luxury items and expensive purchases, but rather with a few dollars here and a few dollars there that slip away with our daily habits that we think nothing of. The latte factor also shows us though how just being mindful of our spending habits and saving a few more dollars a day isn’t enough. Developing that little savings habit does not automatically equal wealth, and despite what some financial experts will try to tell you, no one got truly wealthy just by switching to homemade lattes rather than starbucks lattes.
This is where the second part of the latte factor lesson comes in. You need to develop good savings habits and then pair that with some financial literacy. This means learning the basics of how financial systems work and how to use them to get the money you’ve saved to go to work for you. This means learning the basics of how to use tax advantaged accounts and how to invest your money for growth either in the stock market or in other growth opportunities like real estate.
So in total the latte factor teaches us that developing good savings habits, then pairing that with financial literacy and investing knowledge, equals long term wealth and financial growth over the course of our lives. And THIS I agree with, in order to build financial security and then wealth as an everyday person, you need to learn how to save and invest your money. What I don’t agree with, is what the latte factor gets interpreted as, which is probably what came to mind for you when I mentioned it at the start of this episode.
What The Latte Factor Does Not Mean
It drives me crazy how the really useful lesson of the latte factor gets twisted and morphed into this judgemental statement towards young people about how they’re mismanaging their money, because this absolutely destroys what the latte factor is actually trying to teach us. What I see it get morphed into all the time is ‘Millennials can’t afford houses because they’re buying $5.00 lattes a day.’ Annoying, and also not true. So, for the next time that someone says this to you, let’s walk through why this is not true, so that you can tell them, and then you can tell them what the latte factor actually means and how you are in fact using the theory correctly to build long term wealth for yourself. It’ll be fun.
In reality, if you’re cutting out your $5.00 a day latte to save for a down payment, you’re likely not going to be investing that money to earn a 10% return because that’s too risky with the money you want to have available for a home. So right away you lose that compound interest growth effect, which is really what the latte factor is based on. The average price of a down payment for a home in Canada this year is $33,175.00 for 5% down. This means that by saving your $5.00 a day it’s going to take you just over 18 years to save your down payment, in today’s market, not even considering where house prices are going to be in 18 years. So the next time you see or hear a statement like this, don’t let it get to you, stick to your guns and stick with the real plan outlined by the latte factor, and let’s all just hope that the housing market gets better for us all. So, millennial rant over, now let’s take a moment to look at how money compounds so you can really understand how saving and investing $5.00 a day can turn into $1million by the time you retire. After we look at compounding together, I’m going to finish today’s lesson by giving you the blueprint for how you can apply the basic principles of the latte factor to your own life if you think that it sounds pretty good to be a millionaire one day too.
How Money Compounds
I briefly walked through this a few minutes ago, but don’t worry if you’re still not entirely clear on how saving $5.00 a day can make you a millionaire, I’m going to break it down in a bit more detail for you here. So the latte factor works not through the slow accumulation of $5.00 a day, but rather through investing that $5.00 so that your money can grow and compound. Let’s look at two different scenarios here:
Scenario 1: Kayla learns the basics of the latte factor, switches to homemade lattes, and starts to save $5.00 a day. She does this for 40 years, and at the end of the day she’s saved a total of $73,000.00.
Scenario 2: In the second scenario, Kayla learned how to use the stock market to make her dollars work for her and keep earning more dollars instead of sitting and depreciating in a savings account. She still saves $5.00 a day, which she sets to automatically transfer to her investment account to be invested every single month. She invests in ETF’s, which we’ll say are going to earn an average rate of return of 10% a year. For 40 years, she keeps saving and investing that same $150.00 a month, which begins to earn, and compound, and by following this regime for 40 years, she turns her $5.00 a day into just shy of $1million.
Compound interest happens when you invest the money that you’ve saved, and then you earn interest on that money and invest the interest. Now you’re earning interest on the original principal you invested plus the interest you already earned on that, so you’re earning and even greater amount of interest now. And this process of earning interest on your interest adds up considerably over time so that your $5.00 a day turns into $1million mostly through earning interest on your interest all added together over the years, rather than on the relatively modest principal sum that you yourself saved.
Now this was a really quick run through of the concept, and I’m not going to go into deep investing detail in today’s episode because I really want to get to the next part of the lesson which is how you can actually use and apply the latte factor to your own life.
Applying The Latte Factor
So I’m sure what you’re wondering now is how you can take this information, and apply it to your life. So, I don’t know you, and I’m not going to sit here and tell you to cut out your $5.00 coffee and muffin purchase every day because I don’t know why you make that purchase. Maybe you’re a single parent and by the time you get the kids out to school you only have time to stop and buy a coffee and muffin before getting to your job, so that’s actually an important purchase for you to make every day. I don’t want to come down on or to judge the ways that you choose to spend your money, and I hope you don’t let other finance educators do that to you either. Instead I’m going to show you the tool that I use myself, so that you can use it to analyze your own spending patterns, and make conscious spending and saving decisions according to your own financial values.
This is where today’s lesson actually gets really easy. To apply the latte factor to your own life, all that I want you to do is to track your spending every single day for one week. Absolutely every time you make a purchase, you need to either take out your notebook or take out your phone and write down what you bought, and exactly how much it cost. At the end of the week, take a look at your spending, and you’ll likely find some spending habits that surprise you. You’ll probably find that you’re spending more money in some areas than you realize, or that you’re spending money on something that doesn’t add any real enjoyment to your life. Then, rinse and repeat, do that again, track your spending for the next week, and then the next to get a good idea of what your patterns and habits are.
The key here is to not just track your spending, but to look through it, analyze it, and honestly ask yourself where are areas that you can cut back. Maybe you do have a coffee and muffin habit that you can kick, maybe you’re paying for multiple streaming services and only need one, maybe you’re spending way more money eating out than you realized and can easily cut back by packing your own work lunch some days, or inviting your friends out for activities other than spending money at restaurants. Every person’s spending habits, and needs, and wants, and financial values are different. So you want to understand what yours are, and then use that knowledge to find out where you can start saving this ‘latte factor’ money every day.
If you’re having a hard time finding or choosing areas to save once you’ve done this spending tracking activity, I recommend watching a lesson I recorded all about values based spending, again I’ll link that below. This episode is going to help you start to critically analyze your financial values and create a spending system that still lets you enjoy your money, without overspending in certain areas or dealing with buyers remorse and guilt for your spending.
Once you’ve identified one or more areas that you can start saving money in, then start doing that, start changing your behaviors and start saving that money. I recommend automating it for yourself, and setting up automatic transfers to move that money out of your daily spending account and into a savings account. From there, there are loads of different ways that you can save and invest. I recommend starting off by putting your saved money into tax advantaged accounts. If you’re in Canada, like I am, this means saving your money in an RRSP and a TFSA so that you can save even more money by lowering your tax burden. Then you buy and hold simple and safe investments within these accounts, using the stock market. Again I recommend looking at some investing specific lessons after this, but the easiest way to do this is through purchasing ETF’s that you plan to hold for a long period of time, none of this day trading nonsense. Depending on the rate of return of what you’re invested in, and how long you stay invested for, your money will start to earn compound interest, it will start to add up, and you will start to grow your wealth.
To summarize, the blueprint you need to follow to apply the latte factor to your life is to:
Track your spending
Identify areas where you can save some extra money
Save that money and set up automatic transfers to get it out of your daily account so you don’t feel tempted to spend it
Contribute the money you’re saving to a tax advantaged account like an RRSP or a TFSA
Buy and hold long term investments like ETF’s within those accounts and avoid the temptation to mess with them.
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