Hello and welcome back to Mortgage Advisor on F.I.R.E. This week I will discuss opportunity cost, and its relationship to compound interest.
I want a holiday. I should be gearing up to travel to Romania in three weeks but that trip is not going ahead now. Even if the flights were running and there was not a quarantine on either side of the journey, none of us who should be travelling think it’s wise to risk getting on a plane. It’s not just the danger of catching the virus, but also the risk of passing it on. This is something that many people don’t seem to grasp when they talk about having their freedoms taken away from them. First of all, no democracy is completely free. If it was completely free, society would collapse into anarchy. Part of living in a democracy is giving up certain freedoms to the state so that the safety, well-being and prosperity of the group can be promoted. I had this argument with an American woman on Facebook recently. She was adamant that in the US, none of their freedoms are restricted by the state. My response was; what about the freedom to practice medicine without a licence? What about the freedom to kill someone you don’t like? Even in a “free” society, we’re never truly “free”. With this virus, we can’t be trusted to act responsibly as a nation because time and time again we have demonstrated that we don’t. Each individual person has a low risk of catching coronavirus, and an even lower risk of dying from it. However, some people will catch it, and those people will pass it on, and the people they pass on to will continue to spread the virus which means someone down the infection chain will die. It’s a similar concept to the lottery; each person has a tiny chance of winning the jackpot, but there is an overwhelming chance that someone will win it.
The search has now started for our first BTL property. I had a video call this morning with my JV partner and we’ve agreed on the criteria for our search. It’s frustrating that we will not be able to physically view properties any time soon. Although viewings have started up, it’s only for those from a single household, which means we would have to arrange different viewings. I’m hoping we can secure a property before the end of quarter-three which would then allow for at least six-months until the start of the new financial year. The six-month period is important because you can’t generally remortgage or borrow more money on an existing mortgage until you have had your current mortgage for six-months. Recycling the deposit is an important part of our business plan, and I’m working to a deadline of 31/12/2023 to be able to retire.
Current Weight: 116.8kg (down 1.9kg from last update).
Current Body Fat: 41.2% (up 3.1% from last update).
Weekly Goal: lose 0.5kg
Ultimate Goal: 90kg
The first week of my new health push has gone well. Although I’m using the principles I apply to my financial life to help with my health, there are some important things to consider. When I check my bank balance, or my investment values, I know that at that specific point in time the value is true. When measuring your weight, body fat percentage or BMI, the figures can vary minute to minute. Over the course of a day, it’s not unusual for your weight to fluctuate by a couple of kilos. So, care has to be taken when looking at small data sets. The key to measuring my health stats (weight, body fat and BMI) is to look at trends over time. I will not see the real impact of the changes to my activity levels and diet for several weeks.
Premium Bonds: £15,100 (up £25 from last update).
Stocks and Shares ISA: £8,143.38 (down £241.83 from last update).
Fuck It Fund: £5,025.49 (up £10.00 from last update).
Property Value: £181,626 (no change from last update).
Total Assets: £209,894.87 (down £206.83 from last update).
Residential Mortgage: £144,372.10 (no change from last update).
Total Debts: £144,372.10 (no change from last update).
Total Wealth Figure: £65,522.77 (down £206.83 from last update).
Investment Income in 2020: £31.44 (no change from last update) (target £2,000).
I’m pleased with my Premium Bond and Fuck It Fund values. Although I’ve hit the target for each, I am still drip feeding money into those assets. I’m continuing to invest in my ISA as well. Since the last instalment of this blog, I have invested several hundred more into the ISA but the value has gone down. I’m not worried in the slightest though. This is the ideal time to be snapping up shares and units in funds because the prices are so low. All those extra units will turbocharge the growth in value of my ISA once the stock market stabilises and starts to grow again.
I have been in two minds about whether to pay my mortgage down at a faster rate or use the money to invest. I keep coming back to the same conclusion; rates are very low and I’ll never have debt this cheap again. Also, over the next twenty-years, inflation will erode the value of the debt even if the cash total remains constant (it will actually also reduce as it’s a repayment mortgage). Think about it in these terms; £100,000 now will buy less than £100,000 would in 2000. Just as £100,000 will buy more now than what it will in 2040. The value of money does not remain constant over time. This is why taking out BTL mortgages on interest only makes so much sense. You might take out a £75,000 mortgage on a £100,000 property, but as inflation works over time, that £75,000 debt will be worth less in twenty-years and the value of the property will have increased as well. Also, paying extra on the mortgage has another important limitation when you consider the opportunity cost of the funds applied to the mortgage.
The opportunity cost is the potential loss incurred by ignoring one option in favour of another option. It’s best to illustrate with an example. I’m going to use a season ticket for Sheffield Wednesday, the club I support, as my example.
The cost of a season ticket for the area of the stadium I like to sit in is £555. For the £555 I get to watch every league game Sheffield Wednesday play at their stadium for the next season. The opportunity cost of spending £555 over the next five-years is £768. Over the next ten-years, and twenty-years it is £1,115 and £2,147 respectively. You’re probably wondering what the hell I’m talking about, so let’s break it down…
Instead of spending £555 on a season ticket, I could have invested that money in my Stocks and Shares ISA. Assuming 7% annual growth (historically it’s closer to 10%), that £555 would increase in value to £768 in five-years, £1,115 in ten-years and £2,147 in twenty-years without any further investment and allowing compounding to work its magic. The question isn’t really whether the season ticket is worth £555, but rather if it’s worth £555 spent now instead of having more money later down the line.
The principle can be applied to the daily latte that I used to enjoy pre-lockdown. The approximate opportunity cost of a £3.50 latte in twenty-years is £13.54. I’ve found that calculating the opportunity cost of a purchase is a good way of talking myself out of an impulse buy. It’s possible to go too far with this concept. Life should be enjoyed, and I like my daily latte. However, I’ve successfully talked myself out of learning to drive as I have no desire to own a car, and pay for petrol, tax, insurance and the up front cost of actually purchasing the car. I have no desire to regularly spend £50-£100 a week getting drunk. I like an occasional night out, but I mean occasional. I’m not suggesting people should be wandering the supermarket calculating the opportunity cost of choosing Heinz baked beans over the shop’s own brand; like I said life is meant to be lived and enjoyed. This practice is better applied to luxury or discretionary spending.
Another example; you are buying a new iPhone outright. You want the best and newest model; say, the iPhone 11 Pro Max, with 512gb of storage. Buying the phone without a contract will cost £1,499 (correct at time of writing). However, the iPhone Xs with 64gb storage will cost less than half that, at £710. I’m still using an iPhone 7 Plus that I bought three-years ago and it’s still going strong. The opportunity cost of opting for the more expensive model, in this example, is £789 now, and in twenty-years £3,053. I suspect some of the figures here will be surprising to some people. The power of the opportunity cost calculation comes from compounding, and it is through compounding that the door to FIRE is unlocked. In order to become financially independent you have to switch from working for money, to making money work for you. That is what compounding is; money making more money.
Why Rate of Return is Vital to Compound Interest
What I am about to say will contradict what I said in an earlier post, but I will explain why I am comfortable with the contradiction. I have my cash savings held in a bank account that has a rate of interest that is acceptable. It’s not the best rate I could get, but it’s acceptable. I like the interface with the bank’s app, and customer service and ease of account management counts for a lot. Also, it’s not a large sum in the grand scheme of things. Between my Fuck It Fund and the numerous other pots I have to save for holidays, service charges, home improvements and an emergency fund for my cat, being able to effortlessly manage the account is more important than earning an extra 1% on that balance.
However, when we are talking about large sums in the tens or hundreds of thousands, the rate of return can be so much more important. I will now demonstrate with some examples.
If £10,000 was placed in an investment returning 7% per year, after twenty-years your investment would be worth around £26,000. However, if you raise the rate of return to 9% then the investment would be worth over £38,000. Raising the rate of return to 15% means you would have over £163,000 after twenty-years. This is the power of compound interest.
Thank you for reading this week, and I hope you have a great week ahead. If you are following F.I.R.E. or would like to know more about it, please get in touch via Twitter (https://twitter.com/NowWeLive01) or leave a comment on this post.