There is a very famous quote:
A penny saved is a penny earned.
A very simple, but very powerful concept. It has been more recently rephrased as…”a dollar saved is actually more than a dollar earned”. It is this perspective that has had such a profound effect on my financial mindset. I’ll try and unpack this further…
We live in an age of instant gratification — we are trading tomorrow’s time for today’s happiness.
As Madonna’s famous 1984 song goes “we’re living in a material world” — a hyper-consuming society, nowadays fuelled by Facebook’s smart marketing algorithms and instafamous influencers. It is now the norm to spend a dollar over saving it, supercharging our appetite for consumer debt like credit cards and buy-now-pay-later services.
There is one old saying that really summarises it for me:
Spending money you don’t have, to buy things you don’t need, to impress people you don’t like.
And I’ll admit I am definitely guilty of this. But it really got me thinking…
Where does all my money go?
Do I spend money efficiently?
Does each purchase add significant, or only marginal value to my life?
It is that last question that led me to better understand the utility of a dollar in the earn, burn and invest equation.
What does it take to earn a dollar?
In Australia, income is taxed at progressive or marginal rates. Meaning that the Government increases the set tax rate, the higher the income bandwidth or “bracket”. (Refer Australia Tax Office (ATO) for further details. Also ASIC’s MoneySmart Income tax calculator is a handy tool.)
For the purpose of an example, I will use the average Australian income of $85,000. Based on the ATO’s income tax rates for the financial year 2019/20, every additional dollar the average Australian earned would be taxed at 32.5% (i.e. 32.5c for each $1 for those with income in the ‘$37,001 to $90,000’ bracket).
In other words, if the average Australian was to receive an extra $1 from overtime, a pay rise or bonus, they would only pocket 67.5c and pay 32.5c in taxes. Looking at it from a different perspective — time — that’s equivalent to 20mins (= 32.5% x 60mins) for every additional hour worked!
An alternate view is to understand how much it takes to earn a full dollar, post-tax. At the same tax rate to ‘take home’ $1 after-tax, you would have to earn about $1.48 (= $1 / 67.5%). So that daily $5 coffee is really costing $7.40. Catching my drift?
It is this thinking that challenges if the perceived value of a purchase equals or exceeds the actual cost, which includes income tax paid and your hard-earned time. Ideally prompting questions like — do I actually need to buy this? Does a cheaper substitute or alternative exist? Can I wait for a sale or use a discount coupon?
Now, this was not intended to have a crack at our tax system, but merely to provide a perspective on the cost of earning, and the cost of burning.
The power of compound interest
Albert Einstein once quoted the following about compound interest:
The person who understands it, earns it; the person who doesn’t, pays it.
– Albert Einstein
Compound interest is simply interest earning interest on itself and accumulating or snowballing over time.
Imagine you had $10k to invest for 30 years, added no more money and earned an average of 7% return annually (net of fees and taxes). At the end of the 30th year you would be pleasantly surprised to have over 7.6 times your initial investment — see chart below.
Imagine if you started with $100k!? Or if you could contribute, say $1k, each month?
Now let’s look at the other side of Einstein’s quote. This time let’s consider a $10k personal loan for a car, borrowed at 10% p.a. interest and repayment schedule of $250 per month over 4 years.
The chart below shows the outstanding balance (blue) gradually reduces with each monthly repayment (green). But at the same time the amount of interest paid (orange) increases — totalling 22% of the original loan amount!
You end up forking out $2,213 for the convenience of having the money in your pocket sooner than later, and the lender pockets the profit.
Imagine if you could shop around for a better interest rate? Or increase your monthly repayment?
Or avoid the loan altogether?! Like purchase the cheapest car your ego can afford rather than the latest Telsa.
Now it is possible for debt to snowball out of control — if repayments do not exceed the interest accrued, then the outstanding balance will increase not decrease! This would cause a world of hurt, hence the key to managing the adverse interest effect on debt, is reducing the principal.
Einstein was all over it. The two take away messages for me were:
- Interest is better in my pocket than the banks
- Interest can earn passive income while I sleep
To go one further, the impact of interest can be better appreciated over the longer term when considering a mortgage (try the Mortgage Calculator) or investing in a broad based index like ASX200 or S&P500 (try the Vanguard’s Interactive Index Chart).
The opportunity cost of spending today’s dollar
So…to spend the dollar, or not to spend the dollar? That is the question.
But is it? Or is the question more like…to pay interest, or to earn interest?
Hmmm, I think they go hand in hand.
So…what’s the executive summary? Well, the opportunity cost (read sacrificed cost) of choosing to spend borrowed money now instead of saving and/or investing for tomorrow, has the financial potential to be equal to:
= income tax paid + interest paid on debt + foregone investment returns
But you know what? There is a finite resource that often doesn’t get considered…time. You end up sacrificing more of your time — to work, to pay more taxes and to profit others, instead of putting your money to work to regain you time.
It was the above realisation that when I spend an extra dollar, I now consider if I’m maximising its utility — is it adding significant or marginal value to my life? And it is this shift in mindset that has improved my attitude towards spending, and in turn, investing.
I now check myself before I add an item to my physical or electronic shopping cart. Can that dollar provide better utility elsewhere?
Can I use the power of compounding in my favour (investing) rather than against me (debt)?
For each additional dollar that I use to repay debt, save or invest, rather than spending it — I decide to trade perceived marginal value today for appreciated value tomorrow, meanwhile recovering time!
TIP: ASIC’s MoneySmart website has some great resources like calculators, apps and tools to run saving, investing, loan and compounding scenarios.