Whenever I have a couple of free hours, I like to stroll down to the local coffee shop and treat myself to a cafe mocha. And I’m not alone. Helaine Olen, writing for Slate, says Americans consume about 4 million gourmet coffees each year from Starbucks alone — and that doesn’t count the millions consumed at other coffee establishments.
However, according to financial guru David Bach, by treating myself to this little luxury, I’m sabotaging my financial future. Bach argues that the key to wealth is to give up small luxuries, like a daily latte, and channel that money into investments. He uses the term “the latte factor” to refer to all the small, hidden budget busters that are stealthily siphoning away our cash.
Bach has used this claim in nearly a dozen bestselling personal finance books, as well as numerous seminars, speeches, and TV appearances. But other financial experts argue there’s a big problem with the latte factor: It doesn’t work. They say cutting small expenses can’t make you rich — and fixating on them leads you to overlook the big changes that can.
The Case for the Latte Factor
Bach’s argument for the latte factor goes something like this: The key to success is to make investing automatic. If you have a small sum deducted from each paycheck and put it into investments, and those investments continue to bring in money year after year, then after 40 years, you’ll have enough to be financially independent.
However, finding a small amount to set aside for investing is hard when you’re living paycheck to paycheck. Bach says the best way to do it is to stop wasting money on little things like your morning latte. In an interview with CNBC, Bach calculates that if you redirect $5 per day from coffee into investments earning a 10% return, in 40 years you’ll have close to $950,000.
Bach stresses that this principle isn’t only about lattes — it applies equally to any small, unnoticed expense in your budget. For instance, maybe you spend $50 per week going out to lunch or $6 per day on cigarettes or $50 per month on cable TV. Bach has added a latte factor calculator to his website to show how much your own particular indulgence is costing you.
Other financial gurus have eagerly embraced the idea of the latte factor. These include:
- Suze Orman, who says in a CNBC interview that a daily Starbucks habit is “peeing $1 million down the drain.”
- Jean Chatzky, who argues in “The Difference: How Anyone Can Prosper in Even The Toughest Times” that “overspending is the key reason that people slip from a position of financial security into a paycheck-to-paycheck existence.”
- Tim Gurner, an Australian real estate mogul, who told 60 Minutes that millennials can’t afford to buy homes because they’re frittering away all their money on “smashed avocado for $19 and four coffees at $4 each.”
In short, the latte factor has provided financial experts with an easy, sound-bite-friendly way to explain why so many people today are struggling financially. Conveniently, it points the finger at individuals for their own money woes, letting big business and government off the hook.
Bach’s formula makes the solution sound simple. All you have to do is cut a few small things you don’t really need, and all your financial problems will be solved — with no need to tackle any bigger, systemic problems like falling wages, rising home prices, or skyrocketing student loan debt.
The Problems With the Latte Factor
In principle, Bach’s insight is a sound one. Small, regular expenses do add up over time, after all, and small, regular investments can do the same. In theory, diverting money from one to the other should be a good way to build wealth.
But other financial experts, such as Olen and Ramit Sethi of I Will Teach You to be Rich, say this idea just doesn’t work in practice. In the first place, Bach’s math is more than a little fuzzy. It’s also based on an unrealistic picture of how struggling Americans spend their money.
The Mathematical Problem
In her Slate article, Olen breaks down the problems with Bach’s math. She says that in his eagerness to come up with an impressive-sounding total for how much your daily latte is costing you, he fudged several details.
- Cost Per Latte. When Bach first discussed the latte factor in his 1999 book, “Smart Women Finish Rich,” he assumed a typical woman spends $5 a day at Starbucks. But in 1999, a latte cost $2.50 at most. Bach padded his estimate by tacking on $1.50 for a cookie and another dollar per day for sodas and protein bars.
- Cost Per Year. Starting with that inflated $5-per-day figure, Bach calculated that his subject’s expenses for coffee and snacks would come to “almost $2,000 a year.” But $5 a day times 365 days doesn’t come to $2,000 — it’s only $1,825. Once again, Bach rounded his number up to make it look more impressive and exaggerate its impact.
- Investment Choice. Bach assumed his subject would invest all of her $2,000 savings l in stocks. That’s an incredibly risky asset allocation. According to the standard “rule of 110,” the percentage of your assets in stocks should be about 110 minus your age. Even a 22-year-old wouldn’t buy only stocks, and no one would keep doing it for 40 years.
- Return on Investment. Bach then claimed this all-stock portfolio would grow at a steady 11% per year. He said this was the average growth rate “over the past 50 years,” but that period — 1949 to 1999 — was a very strong one for the stock market. In truth, the average annual stock market return from 1926 to 2020 has been closer to 10%.
- Inflation and Taxes. Bach also failed to factor in the cost of inflation and taxes. According to the AARP’s retirement calculator, adjusting for inflation drops the 40-year return on an annual $2,000 investment by more than 67%. And while you can delay taxes with a tax-deferred plan like a 401(k) or an IRA, you can’t avoid them forever.
If you correct all these errors, the total return on the latte factor looks a lot less impressive. Let’s start out by assuming your daily latte costs $3, not $5. You divert this money into a balanced portfolio containing both stocks and bonds, which has an average annual return of around 8.7%.
Take out 15% for taxes, and after 40 years of diligent saving, you’ll have about $142,000. Adjust for inflation of 3% per year, and the actual buying power of your investment shrinks to around $43,500. That’s nowhere near the $950,000 promised by Bach — and not much to show for 40 years of caffeine deprivation.
The Economic Problem
Trying to reach financial independence by cutting out a $3 daily latte isn’t likely to work. But there’s a more fundamental problem with the latte factor: it assumes you have that $3 per day to save. Bach’s premise is that it’s the little things in the average person’s budget that hold them back from working toward their financial goals. But according to many economists, it’s really the big things.
Two of these economists are Amelia Warren Tyagi and her mother, U.S. Sen. Elizabeth Warren. In 2007, they published “The Two-Income Trap: Why Middle-Class Parents Are Going Broke.” When they first began researching it, Sen. Warren told The Harvard Gazette, she expected it to be “a story about too many trips to the mall, too many $200 sneakers, too many Gameboys.”
But instead, the authors discovered families are spending much less on these luxuries than they did decades ago. Clothing, packaged foods, furniture, and appliances all account for a much smaller share of the average family’s budget than they did in the 1970s. At the same time, large fixed costs — the things a family can’t easily cut back on — have gone up exponentially.
In the early 2000s, the average family devoted 75% of its discretionary income to just three large expenses: housing, health care, and education. For the average family in 1973, these three items accounted for only half of their discretionary income. As Warren put it in her interview, “People aren’t going broke over sneakers. People are going broke over mortgages.”
That doesn’t come as news to struggling Americans. Tim Gurner’s finger-wagging remarks about avocado toast elicited tart responses from millennials on Twitter about how they’d blown all their money on rent and transportation.
Other research also confirms that the millennial generation, on the whole, is quite responsible with its money. Gen Yers devote more of their income to savings than previous generations, have less credit card debt, and spend less on clothing, entertainment, and alcoholic beverages.
In short, it’s not wasteful spending that’s holding millennials back from buying homes. It’s lower incomes and higher housing prices than previous generations enjoyed. According to a CNBC analysis, even if millennials cut their spending on dining out to the level of baby boomers, they’d still need a jaw-dropping 113 years to save enough for a down payment on the average American home.
What Really Works
Across the board, it seems, the furor over “frivolous” spending is misplaced. Yes, for a family that’s on a tight budget, every dollar counts, and cutting out small expenses can help a little. But the simple fact is that for the average American, it won’t make the difference between going bankrupt and retiring rich.
So, if giving up a cup of coffee each morning won’t make you rich, what will?
Focusing on the bigger picture.
That means looking not just at “unnecessary” expenses, but at the necessary ones too. It means looking at your income as well as your expenditures so you have as much money as possible to save and invest. And it means choosing the right investments to help your money grow at a strong and steady rate.
Minimize Your Fixed Expenses
In most cases, it’s the big, fixed expenses — not the little ones — that derail your budget. So if you want to save more, it makes sense to focus on these large expenses. For most people, these include:
First, think carefully about whether renting or buying a home makes more sense for you. If you’re not sure, you’re probably better off renting. Buying a home before you’re ready ties you down to a fixed payment you can’t easily get out of.
If you choose to rent, aim to keep your rent payment down to one-third of your take-home pay, tops. Nationwide, the average renter paid $1,124 in February 2021, according to Statista. If that’s more than you can afford, consider looking for a place in a more affordable neighborhood or a home you can share with a roommate.
If you decide to buy a home, make sure it’s a house you can afford. Consider buying a smaller house to keep your mortgage payment low, and get the lowest interest rate you can on that mortgage. Or look into house hacking strategies, such as renting out part of your space, that will cover your entire mortgage cost.
A 2017 report by the JPMorgan Chase Institute found that the average family paid just 1.6% of its income on out-of-pocket health care costs. However, that percentage wasn’t the same across the entire population. It varied by age, income, area of the country — and most of all, by health status.
The report found that just 10% of the population was responsible for about half of all out-of-pocket health spending. These unlucky families spent 9% of their take-home income on health care. Moreover, the highest spenders were often the same families from year to year. Nearly half of all families in the top 10% of health care spenders for 2015 were also in the top 10% for 2016.
The most important way to keep your health care costs down is to have health insurance. The premiums can be expensive, but not as expensive as the thousands you could pay for a major health emergency without insurance. And if your income is low, you can probably get a subsidy under the Affordable Care Act (aka Obamacare) to help cover the cost.
The second most important way to reduce your medical bills is through preventive care. Schedule regular checkups with your doctor and dentist and have small problems checked out before they turn into big problems. It will save you a lot of pain, stress, and hassle in addition to money.
Along with housing and health care, education costs account for the bulk of the average family’s budget. The best time to save on this expense is before you’ve actually started college. At this point, you have several options for keeping your costs down and avoiding overwhelming student loan debt. They include:
- Taking advanced courses in high school to reduce the number of credits you need to graduate
- Attending a low-priced community college for your first two years
- Taking advantage of all available grants and scholarships
- Looking into free colleges
- Considering a career path that doesn’t require a degree
If you’ve already finished school and are now struggling to pay off student loans, there are a few ways to reduce the burden. If interest rates have fallen since you were a student, see if refinancing your student loan could lower your payments. Also, look into student loan repayment and forgiveness programs that have the potential to cancel all or part of your debt.
Pro tip: If you’re being held back by student loan debt, look into refinancing with Credible.com, where you can get multiple loan offers in two minutes. Plus, Credible.com is offering Money Crashers readers up to a $750 bonus when you refinance your student loans. Learn more about refinancing with Credible.com.
According to an annual survey by the Bureau of Labor Statistics, the average American household spent $10,742 — about 13% of its income — on transportation in 2019. By far the biggest chunk of this was for car-related costs. Families spent an average of $4,394 on car purchases, $2,094 on gas and other fuels, and $3,474 on other vehicle costs, such as maintenance.
One way to reduce these expenses is not to own a car. However, depending on where you live, a car-free life might not actually save you money. If you regularly have to go places you can only reach by road, the cost of auto rentals, cabs, or ridesharing could easily outweigh the savings.
If you can’t reasonably live without a car, you can still lower the amount you spend on it. If you can, buy a car for cash to avoid loan payments. Also, crunch the numbers to see if buying a used car will cost you less in the long run. And hold on to your old car as long as you reasonably can before trading it in.
Maximize Your Income
When it comes to saving money, your spending is only half the picture. The other half — and, according to some experts, the more important half — is how much you make. As Sethi points out in an interview with CNBC, “There’s a limit to how much you can cut, but there is no limit to how much you can earn.”
To increase your income, Sethi and other financial experts offer the following ideas:
Find the Right Job
It’s certainly helpful to choose a career that pays well. Tom Corley, who spent five years learning about multimillionaires for his Rich Habits study, tells CNBC the easiest way to get rich is the “Saver-Investors path.” It involves saving a good chunk of your earnings, which is much easier to do on a good income. Corley says most Saver-Investors earn six-figure salaries.
However, according to Corley, choosing a job you love can be just as important as choosing one that pays well. The wealthiest people in Corley’s study followed the “Dreamers” path: pursuing a dream, such as owning a business. They loved their work so much they were willing to put in long hours, go without vacations, and struggle for years before they finally made it.
While you may not care to be this extreme, you’re much more likely to succeed at your job if you’re doing something you love. So if you’re just getting started in your career or thinking about changing careers, be sure to consider not just what a job could give you, but how much of yourself you’re willing to give to it.
Get a Raise
Sethi says the first place to look for extra money is at the job you have now. Because you’re already earning a salary, your first move should be to renegotiate it.
However, simply asking for a raise doesn’t guarantee you’ll get it. Here are some tips that can help:
- Time Your Request. The best time to ask for a raise is when your employer has money to spare. Keep tabs on how the company is doing, and make your request when its finances are strong. Also, choose a time when your boss isn’t too busy. Try to get an appointment after lunch, not before, so your boss won’t be cranky from hunger.
- Do Your Homework. Research how much people in your position make at other companies using a site like Educate To Career or Glassdoor. You can also ask colleagues on LinkedIn. Figure out how much you’re worth, and take that information to your boss.
- Cite Your Accomplishments. Make a list of important jobs you’ve done for your employer. If possible, include information about how much money your work has made or saved for the business. Point to these accomplishments as you negotiate with your boss.
- Negotiate Effectively. Many of the same negotiation skills that help you haggle over the price of a TV set can also help you if you’re seeking a raise. Be specific about what you want. Show confidence, but keep your emotions under control. Practice your pitch ahead of time so you can present it clearly and smoothly, without stumbling or hesitating.
Earn a Promotion
Instead of just asking for more money to do the same job, you could increase your salary by earning a promotion. This strategy works for a lot of millionaires. Corley found that 31% of millionaires followed the “Company Climbers” path: climbing up the corporate ladder. They made most of their wealth from stock options or a partnership share in their company’s profits.
Here are some strategies that can help you land a big promotion:
- Know Your Boss’s Needs. Anticipate what your boss needs and deliver it without being asked. Instead of waiting for your annual review, ask your boss what you could be doing better, and act on it.
- Be Easy to Work With. Be friendly and agreeable to all your coworkers, not just the ones who control your salary. Steer clear of company gossip and avoid getting involved in workplace disputes as much as you can.
- Continue Learning. Spend time learning new skills and honing the ones you have. Focus on skills specific to your job and also on general ones that can help you in any field, such as communication and problem-solving.
- Go the Extra Mile. Go beyond the requirements of your job to provide extra services that help the company. Be the person who’s willing to stay late, take on an extra project, or help out a coworker.
Start a Side Business
Your main job is the first place to look for more money, but it shouldn’t be the last. Both Sethi and self-made millionaire Grant Cardone say one key to wealth is to have multiple income streams. Instead of cutting out frivolous expenses, Sethi recommends cutting out frivolous uses of your time, such as watching TV, and devoting that time to starting a side business.
Don’t pick a side business idea at random and try to make it work. Cardone says it’s important to make your various income streams “symbiotic.” In other words, your side business should use the same knowledge and skills you already use at work so you don’t have to learn new skills from scratch.
Here are a few examples:
- If you’re a teacher, teach an adult education class, offer tutoring during the summer months, teach English through VIPKid, or write a textbook.
- If you work in a field like publishing, advertising, or Web development, do some online freelance work on the side.
- If you’re in an artistic or creative field, sell your own designs through a site like CafePress, Zazzle, or Etsy.
- If you’re a chef, do some outside work in catering, sell your homemade goodies at farmers markets, or write a cookbook.
- If you have a car that you don’t use all the time, share it through platforms like Getaround and Turo.
Build Passive Income Streams
Along with your regular job and your side business, you can bring in extra money from passive income. Passive income isn’t the same as getting paid for nothing. Rather, it means that you put in the hard work upfront, then continue to reap the rewards for years to come.
Sources of passive income include:
- Income investments such as bonds, annuities, dividend-paying stocks, real estate investment trusts (REITs), and peer-to-peer loans
- An investment in someone else’s business — you can invest through Worthy and earn a 5% return on your investment
- Rent from a rental property or a room in your home that you lease out to a boarder through Airbnb
- Sales of creative works, such as books, videos, or music
- Ad revenue from a blog, website, or online videos
Even if you’re saving tens of thousands each year, it won’t be enough to make you rich if all the money does is sit in a savings account. With the pitiful interest rates those accounts earn today, your money won’t even be able to hold its value against inflation. To grow your wealth, you need to invest.
Choosing the right investments is a huge topic — one that’s far too complicated to cover here. However, there are a few strategies that will help you make the most of your investments, no matter what they are.
- Find a Good Advisor. If you don’t feel confident about choosing the right investments on your own, find a trustworthy financial advisor to help you. If you don’t know any advisors, you can use a tool from SmartAsset to find one in your area. Alternatively, you can choose a robo-advisor with lower fees, such as Betterment.
- Make Investing Automatic. Although Bach got many of his facts wrong, he was right about one thing: Your investments are much more likely to prosper if you make them automatic. At most brokerages, you can set up an automatic investment plan that takes a fixed sum out of your bank account every month and puts it into your portfolio. That way, you can never forget to invest or put off doing it. As a bonus, you automatically buy more shares when their prices are low. You can also use automatic saving apps like Acorns to automatically boost your investments.
- Diversify. In general, riskier investments offer bigger returns. But if you put 100% of your portfolio into them, there’s a chance you could lose it all. That’s why most investing experts recommend diversification. Put your money into a variety of investments so a loss in one area can’t completely bankrupt you.
- Minimize Fees. The more of your money you pay in investment fees, the less you have left to grow. You can keep more of your own money by choosing index funds and exchange-traded funds (ETFs), which have much lower fees than managed funds.
- Minimize Taxes. Taxes also eat into your investment return. Tax-advantaged retirement accounts, such as a 401(k), can’t eliminate taxes completely, but they allow your money to grow tax-free for many years. And some investments, such as municipal bonds, are mostly nontaxable.
Pro tip: If you have a 401(k) or an IRA, sign up to receive a free analysis from Blooom. After connecting your accounts, they’ll check your asset allocation to make sure it fits with your risk tolerance. They’ll also make sure your account is properly diversified and that you’re not paying too much in fees.
Getting rich isn’t as simple as giving up lattes. It requires you to focus on all the different aspects of your financial life: your biggest expenses, your income, and your investments. That’s a lot more work than just going without your morning coffee, but it’s a lot more likely to get you where you want to go.
The good news is that while you’re doing all this hard work, you can continue to enjoy your daily caffeine fix — or whatever other small treats help keep you going. In fact, by allowing yourself these small luxuries, you can fight off frugal fatigue and give yourself the stamina to stick to your financial plan for the long haul.