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Don't trust stupid Internet financial advice. Compounding interest is real
It seems I have turned into the "anti-marketer" police on the Internet, first about "location independent businesses" and now about the time-value of money. A guy on Twitter spit out a moronic tweet,
If you drive a lot of miles out of necessity this is for you.
If you buy a new car for $30k and drive it for ten years it works out to $250/month or less than $10/day.
If you rely on that car to get you and your family where you need to be, and safely, it isn’t a bad deal."
This guy might not be ret**ded but this piece of his advice sure is. I can't tell about him as a whole because this advice is so bad that I don't want to read the rest. He is forgetting the time-value of money. The true cost of the $30K car over ten years is not the cost of the car, but the cost of the investment foregone because of the car. Let's imagine you buy a $15K car instead and keep the other $15K. Compounding interest formula is A = P(1+r/n)^nt
P = principal amount (the initial amount you borrow or deposit)
r = annual rate of interest (as a decimal)
t = number of years the amount is deposited or borrowed for.
A = amount of money accumulated after n years, including interest.
n = number of times the interest is compounded per year
Dont worry, I had to look this up. Let's even skip that and look at the simple interest formula, A = P(1 + rt). If you save the $15K and invest it @ 5%/year, you'll end up with $22,500, or $7,500 more. So now the cost is not $250/month, but $312.50/month.
That's not all, however. 5% a year is conservative. In addition, neither calculation takes into account inflation. More importantly, neither calculation takes into account financing.
If you have $30K in cash to buy a car, fine, but you're also probably in the financial elite, and you're still not earning interest. Most people finance cars. If you finance $15K, you'll probably be paying 5% interest. So you can add another $7,500 on top of your $7,500 in foregone income, under simple interest, and more than that under compounding. So now you are not paying $250/month but rather $375, if you account for foregone gains and for interest.
It's even MORE complicated than this, because the interest in most consumer loans is front loaded. That means you'll spend the first quarter to half of the loan term primarily paying off interest. If you end up having to sell the car.... congratulations, you just paid a lot in interest.
I pointed some of this out to the guy and he said, "Yeah I know buy a $5k hatchback and invest everything else in mutual funds. I love MMM and learn a lot from him, but his car advice is big practical for high mileage commuters imo." Leaving aside that guy's syntax and word misuse, there is a big gap between $5K and $30K, and he knows it or should know it. The reply is sufficiently painful that it reinforces the idea that he's not worth listening to.
It's smart to try not to be a high-mileage commuter, though that's not always possible... circumstances of work and housing sometimes mandate it, and it's a shame we've not implemented the freedom to build new housing. But the guy didn't even begin to address the real financial cost of the thing he's advocating. He says he is a "Personal finance coach with a passion for helping others remove stress and worry from their financial lives." He has 27.5K followers, or about 27 times the number I do, yet I know 10x what he does about finance.
Simple or compound interest aren't Black-Sholes or fancy shit that requires calculus. It's simple math with some exponents, and the calculators are widely available online. Simple math shows the true cost is far higher than $30K. If someone wants to pay it, fine, do it, but to think that $30K is "only" $250 a month is why this guy is giving advice on Twitter and not working in finance. As far as I can tell no one else noticed this on Twitter. The fools are following the fools.
The more you know about finance, the more painful the decisions of many people around you will appear. "Normal" consumption patterns will begin to seem crazier and crazier. You will hear people brag about the "house" they bought, which in fact the bank owns, and you will hear them ignore closing costs (can be 10% of the total) as well as foregone investment opportunities. In some markets buying makes sense, in others renting makes sense. Buying property was great in 2010 - 2014. Probably not so great today.
Electric cars change the cost equations because right now their initial cost is higher and their long-term costs are much lower. That is another important consideration. They also don't spew poisonous fumes into the air, which is nice.
You're poor for many reasons, including because you don't understand compounding interest or that the alternative to spending money isn't sticking it under a mattress, it's investing in an index fund. You're poor because you don't know math. Don't end the week with nothing in your career and don't take financial or health advice from Internet randoms without checking it. The same is true of me. Don't trust what I say. Check it for yourself. Wikipedia says, "The Florentine merchant Francesco Balducci Pegolotti provided a table of compound interest in his book Pratica della mercatura of about 1340." "Richard Witt's book Arithmeticall Questions, published in 1613, was a landmark in the history of compound interest." So this formula is around 400 years old, maybe older, but Twitter guy with lots of followers doesn't know it. What else doesn't he know?