In this post, we will look at the Latte Effect and see whether skipping coffee can lead to wealth. But first, our disclosure:
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The Book That Started It All
I’m sure you heard it more than you wish to remember: “If you just skip your daily to-go cup of coffee, you could retire a millionaire.” This idea is known as the Latte Effect and was popularized by author David Bach in his bestselling book, The Automatic Millionaire.
The Latte Effect is one of the most controversial ideas in personal finance. It has sparked countless debates about the impact of small spending habits on your wealth. In fact, simply mentioning the words “Latte Effect” on any social media platform, like X, can be considered rage bait.
So, does giving up your “latte” actually make you rich? Or is it just another personal finance buzzword that will leave you broke?
Let’s find out!
What Is the Latte Effect?
The Latte Effect refers to how small, regular expenses, such as a daily $5 coffee habit, can add up to a significant amount of money over time.
In The Automatic Millionaire, Bach argues that if you give up that daily $5 coffee and invest that money instead, it could grow into a big nest egg, all thanks to the power of compounding.
Here is what saving and investing $5 per day looks like:
- $5/day X 30 days X 12 months = $1,825 per year or just over $150 per month
- Investing at a 10% annual return (the long-term average nominal return of the S&P 500) for 30 years = nearly $300,000
That’s a lot of money by simply cutting back on a $5 habit, considering the median retirement savings for a 65-year-old is $200,000, according to a 2023 survey by the Federal Reserve.
The Math Behind the Latte Effect
The Latte Effect harnesses the power of compounding. Compounding is a lot like magic, but real. Is as close to a free lunch as you can get.
Compounding is all about earning returns on your returns. When you give compounding time to work, even small amounts of money can grow into a big pile of cash. It is a classic example of exponential growth.
Let’s look at how compounding works using the $150 we saved by forgoing our latte addiction. We will assume we invest the $500 in the S&P 500, which has historically yielded an average nominal annual return of 10%.
*The nominal rate of return is the percentage change of an investment before adjusting for inflation, taxes, and fees.
**Note: Past returns do not guarantee future results.
The Power of Compounding
- Initial investment: $150
- Returns in the first year: A 10% return would earn you $15 in the first year.
- New investment balance: Add the $15 to your $150, and your new balance is $165
- Generating returns on returns: In the second year, the 10% rate of return is based on the $165, resulting in a larger return of $16.50, creating a new total of $181.50.
- Exponential Growth: This cycle will continue to repeat itself year after year, growing faster and bigger the longer it is allowed to continue.
Below is a table that shows how your initial $150 will grow over 30 years.
| Years | 10% Nominal Annual Return |
|---|---|
| 10 | $389 |
| 20 | $1,009 |
| 30 | $2,617 |
The result: After 10 years, the initial $150 more than doubles, and after 30 years, it grows to over $2,600 by doing absolutely nothing other than sitting on your hands. Amazing!
Hold on! It gets even better.
Remember, by cutting out your daily $5 coffee habit, you are saving and investing $150 EACH month, or $1,800 per year. Here is what those returns look like over the same 30-year period if you invest $150 every month:
| Years | Total Invested | 10% Nominal Annual Return |
|---|---|---|
| 10 | $18,000 | $29,076 |
| 20 | $36,000 | $104,104 |
| 30 | $54,000 | $298,706 |
In other words, if all you did was put your money under your mattress, you still would have saved $54,000 over 30 years. Those are unbelievable numbers, and illustrate just how much those little expenses can cost you over the long haul.
Cheaper But Not Free
Obviously, you must factor in the costs of making coffee at home, as the cost of your daily coffee habit doesn’t go away entirely unless you quit cold turkey. The same is true if your “Latte” is takeout for lunch. However, from experience, you’ll find that making these items at home often costs just a fraction of what you’d pay out.
Maximizing Latte Effect Returns
The Latte Effect applies to any small, recurring expense that is not a necessity. This means it doesn’t have to stop at coffee. Here are a few other ways to make the most of the Latte Effect:
- Cut More: The more you can cut back on small discretionary expenses, the more you can save and invest.
- Pay Off High-Interest Debt: Paying off high-interest debt, such as credit card debt, can give you a better rate of return since many credit card interest rates exceed 20%.
- Build an Emergency Fund: You can use your “Latte” savings to build a fully funded emergency fund. Having extra money set aside for emergencies will help prevent you from relying on high-interest debt, like credit cards, to cover unexpected expenses.
The Psychology Behind the Latte Effect
The Latte Effect is not just about math; it’s a mindset and a path toward conscious spending.
The Latte Effect will cause you to pay attention to how you spend your money. It helps you become more intentional with your money. This awareness can have a profound impact on your finances.
The Criticism: Is the Latte Effect a Myth?
Of course, not everyone agrees with the effectiveness of the Latte Effect. That should come as no surprise.
Critics argue that the Latte Effect won’t make you rich or solve your money problems. They argue that skipping coffee can’t solve sky-high housing costs, student loan debt, healthcare costs, and stagnant wages.
And guess what? They’re right!
You won’t be able to buy a house or pay for college by saving $5 a day. Getting rid of an $800 monthly car payment is going to impact your finances much more than skipping a daily $5 coffee, but that doesn’t mean the Latte Effect is worthless.
The Latte Effect helps people focus on their spending habits, while encouraging them to save money, no matter how small the amount. And ultimately, the lessons learned from the Latte Effect can be applied to your bigger expenses in life. The bottom line is that there is nothing wrong with becoming more mindful of our spending and saving habits, no matter what critics may say.
Striking a Balance
When many people hear the term “Latte Effect,” they instantly think: cheapskate.
The Latte Effect isn’t about nickling and diming yourself to wealth. The goal isn’t to become the world’s biggest cheapskate. The key is to strike a balance between being a spender and a saver.
If that fancy cup of coffee is what gets you out of bed each day, keep it. But maybe try brewing some at home a few times each week. Instead of using DoorDash, go pick up your takeout yourself to save on delivery fees and tips. Rather than buying marked-up energy drinks at the gas station, save by buying them in bulk at the grocery store or warehouse club.
Then, take the money you save, even if it’s just $20 or $50 a week, and automate it into a savings or investment account, or direct those extra funds toward paying off high-interest debt. You will be surprised how much money you will save over time by making these small spending changes.
So, Does Skipping Coffee Make You Rich?
Not exactly. But it sets you on the right path to success.
As we saw, saving $5 a day won’t make you a millionaire, but that is not what the Latte Effect is all about. Instead, it’s about making conscious choices with your money and letting the power of compounding work its magic.
Ultimately, the Latte Effect is much more than another gimmicky way to save money. It is about being more mindful of our spending habits and becoming intentional with our money.
Takeaway: What’s Your Latte?
So what’s your “latte”? Is it a coffee and a donut every morning at Dunk’s or that daily lunch at Chick-fil-A? Is it take out most nights after a long day of work? Or grabbing that energy drink from 7-11 on the way to work?
Remember, you don’t have to entirely give up the fancy cup of coffee at your favorite café. Instead, start small, stay consistent, and let compound growth do the heavy lifting. Your future self will thank you.
