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Tuesday, 14 February 2017

The Latte Equation

A favourite of frugality and finance bloggers is the Latte Equation. You can't throw a stone without hitting it, whether it's people saying to ignore the Latte Equation and focus on the big savings, or people talking about whether that $4 a day savings is the basis of a good financial habit, everyone has an opinion. Here's some of my favourite ways to calculate the Latte Equation.

The basic theory

A latte is roughly $4 a day, depending on where you shop. This is a short term happiness boost that is a massive financial drain and represents frivolous spending that could be wisely redirected. That's the absolute basic theory.

Paying down debt

Imagine you spent that $4 a day on your mortgage instead of on a latte. Assuming you only buy coffee on work days, $4 a day, 5 days a week then you are spending $20 a week on the Latte Equation. If you instead throw that $20 at a $300k, 30 year mortgage with a 4.5% interest rate, you can knock 3 years off the repayments. Even more impressive, you save $30,000 on repayments.

Even better (or worse), imagine you have $2,500 in credit card debt. Making minimum repayments this would take twenty-two years to pay off, and cost you $7,600!!! But throw the $20 a week from the Latte Equation at this debt and it will only take you 3 years and $3,243. 

Coffee? Or massive debt reduction?

Investing for the future

In a similar vein, perhaps you have no debt. Or perhaps you're comfortable carrying that debt and you'd rather invest and watch your money grow. Mathematically you're better off investing in the share market for a 7% return (historical average) than paying down a 4% mortgage.

If you choose to invest, your $4 latte could instead be $21,000 in ten years.

Staying sane!

It wouldn't be fair to talk about coffee without talking about the special place it holds in our hearts, and lives, and taste buds, and our ability to deal with people before 9am. Coffee is delicious, warm and my favourite piece of first-world decadence. It is the sweet nectar of life, and without it some of us wouldn't be employed at all, if you catch my drift.

Scientifically, you are actually addicted to coffee! Congratulations! Coffee increases the speed of signals travelling through your brain, giving you that increased pep. Unfortunately our bodies don't like being pushed out of alignment like that and they compensate by creating more neural blockers to slow those messages. At first it works nicely, you drink coffee, get some pep, then the coffee wears off. But your body builds a resistance by creating those neural blocker so you need more and more coffee for the same pep. Then if you try and cut back, you find that those neural blockers are still in place and you feel slow and sluggish. Your body will remove them to bring back its equilibrium, but you'll feel pretty meh during the process.

When asked to give up their daily coffee most people recoil in horror because coffee is life. As a coffee drinker myself I can't argue with that, but I can offer alternatives...

Reduce, replace, remove?

The easiest calculation in the Latte Equation is always simply removing the offending item (coffee) and doing something with the money saved. Of course this ignores the human element, which is why I offer you the alternatives of Reducing and Replacing.

Reduction is simple enough in theory, if not in practice. If you're buying two coffees a day ($40 a week, $53,000 and 5.6 years off your mortgage!) start with dropping down to one a day. Maybe trick yourself by drinking a cup of decaf if you're desperate enough. You could also swap a cup of coffee for a cup of tea, which costs significantly less but only contains 1/4 the amount of caffeine. Bonus points if your office supplies free tea supplies.

Replacing your delicious barista brewed coffee with instant coffee, tea or *shudder* decaf will save you about $15 a week, but it doesn't hit the pleasure centers of the brain the same way. Let's be honest there is a massive difference between instant 'coffee' and a proper espresso. But it turns out making a decent coffee at home is really not that hard.You can buy a decent coffee machine for around $200, and then you can make a latte at home for less than a dollar. Within three months you'll be ahead and can keep enjoying delicious cheap lattes for years. The only downside is you'll probably drink more coffee!

Protip - buy a thermos so you can take coffee in to work, out to the park, on a picnic. Anywhere!

Small wins are just distractions from the big things in life

At the end of all this though, remember we're talking $4 a day, $20 a week. There are plenty of people who will argue that focusing all your mental energies on these small wins is a waste. If I spend an hour a day lamenting my lack of coffee, that's an hour a day you're not spending working for a pay rise, building up a side hustle, learning about investments and money management, calling your bank for a rate reduction, shopping around for better utility pricing etc. etc.

A 50 cent an hour pay rise will more than cover the costs of coffee. Calling the bank and getting .1% knocked off a $300,000 mortgage reduces your payments by $6 a week. Pet-sitting pays upwards of $15 a day to snuggle fluffy puppies. Purchasing another rental should be able to create a 5% return with less than an hour a week ongoing efforts. If all your energies are focused on reducing a $4 a day expense, you might be missing the big ticket items.

And of course, the Latte Equation can be applied to other things in life. Gym memberships can be swapped for going outside saving you $18 a week. You can stop visiting the vending machine and prep your own snacks, putting $15 a week back in your pocket. Friday night beers can be reduced to two instead of three for a $5-10 saving. Getting off the bus and riding a bike can save you almost $40 a week. The world is your (expensive) oyster and the Latte Equation can be applied everywhere!

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