Have you checked the mail today? If so, there’s a decent enough chance that somebody somewhere wants to give you money. Banks are clamoring for you to transfer your balances to them for 0% APR (for the first 12 months or however long it takes you to read the terms and conditions, whichever is longer) or buy a car (as long as it’s new and you take out a 60 or 72 month loan) or refinance your house and pay less each month (conveniently leaving out loan costs you’ll incur by doing so).
According to a 2009 study, 70% of Americans have some kind of debt, 30% carry credit card balances, and 40% have monthly debt obligations greater than half of their monthly income. Mortgages, car notes, and consumer credit cards are the three biggest sources of debt for Americans. For mortgages and car notes, interest rates and APR (annual percentage rate, or the real interest cost with loan fees) are stated so the cost of borrowing is fairly clear. Recent legislation has taken much of the guessing game out of credit card rates, as previously they were buried in paragraphs of legalese.
What the APR can’t tell you is how much that debt really costs. Every time money gets sucked out of checking to cover the mortgage or a check is written to pay the car payment, the opportunity to invest that money is gone. In one or two shots, it doesn’t seem like much. But add it up over time and the amounts become staggering.
The average car payment in America is somewhere between $400-500 per month. For some, this is a one-time loan for a first car and they’ll pay cash for subsequent vehicles. For others, a car payment is an expense. They finance a new car (or even financially worse lease it, which is a whole other post), sell it, and finance another.
What if, instead of paying the bank, you paid your car payment into an index fund? (Index funds cover such a huge portion of an index, such as the S&P 500, that it mimics the overall movement of the market.) The stock market has averaged around 10% per year over its life, but a good money manager is worth at least 2%. We’ll use 12% or 1% per month as the growth rate for our calculations. Let’s also use a 30 year horizon for this calculation.
The math can be done in excel or any financial calculator, and the inputs are below:
Payment = 450.00 (Average monthly payment, or whatever yours is)
Rate = .01 or 1% (Average market return of 12% divided by 12 months gives you monthly rate of return)
Number of Periods = 360 (30 years times 12 months)
Future Value = $1,572,733.86
A car payment invested every month in an index fund will make you a millionaire and then some. Kinda cool, no?
The mortgage payment calculation is even better. For our purposes we’ll use a round figure of $200,000 as a home price. At a 6% rate on a 30 year fixed note, principal and interest (not including taxes and insurance) would be around $1,200 per month. If we plug that number into our above model, we get the following:
Payment = 1200.00 (Average monthly payment, or whatever yours is)
Rate = .01 or 1% (Average market return of 12% divided by 12 months gives you monthly rate of return)
Number of Periods = 360 (30 years times 12 months)
Future Value = $4,193,956.96
Paying yourself a house payment, instead of the bank, yields over $4 million after 30 years. The last step is to see what that money would look like if you retired after 30 years of paying yourself.
Let’s say that you started early and managed, by 40, to have your house and car completely paid off. At that point, you still took the money out every month, but it went into funds earning 12% per year. By age 70, you’d have $5,766,690. At that point, if you wound down into more conservative investments earning just 5% per year, your retirement income would still be staggering. The annual proceeds alone, without ever reducing the principal, would amount to $288,334.54 per year. That’s a pretty nice income for anyone, much less someone with no house payment, no car payment, and no job. Plus you’d leave a sweet nest-egg for your kids, who probably wouldn’t need it because they were as smart as you were with money.
If you really wanted to go all out and leave nothing for your family, a 30 year horizon would mean you could really celebrate your 100th birthday in style. Your investment would spit off $371,482.12 annually.
Taxes, capital gains, and many other factors would affect these dollar amounts, but it’s easy to see how powerful compound interest can be. Also keep in mind these amounts do not include the forgone finance charges on cars and homes, which would make the numbers even larger.
The expenses need not be so large to make a real difference. Just $100 per month yields almost $350,000 at 12%. That’s a few lunches and Starbucks for me. If you really squeeze to cut $300 out monthly and invest, it’s a cool million dollars after 30 years. Small amounts over long time periods can make a huge difference, and it doesn’t take much to get started.
