What is the Latte Effect and Is It Important?

A common issue pointed out in many personal finance publications (from mainstream magazines to unheard of blog posts) is the problem of “the latte effect”.

What is the latte effect and is it truly a significant problem in most individuals’ personal finances? Let’s take a deeper look.

What is the Latte Effect?

The latte effect is the phrase used in personal finance to describe those small, everyday expenses that slowly drain of us of money. It is used when talking about budgeting and all the surprising ways we find to spend money every week or month. The total amount of money spent is then contrasted with what that money could do for you in terms of paying off debt, saving up an emergency fund, or investing for retirement.

The original example of the latte effect is, of course, lattes and other coffee drinks. However, the latte effect could be used to describe other spending: maybe you buy a lot of songs on iTunes or go out to eat a lot.

Here’s an example of the latte effect in action. Let’s assume someone spends $4 every weekday on a coffee drink of some sort at a store like Starbucks or Dunkin Donuts. The latte effect says that spending that amount of money will, over time, become very significant.

Spending $4 per day, 5 days per week, on coffee is $20 per week. Assuming someone takes 2 weeks off per year for vacation, they’re spending $20 for 50 weeks. That’s $1,000 per year.

Further calculations can be done on how important that $1,000 is. Imagine dropping your credit card balance down by $1,000, how much interest would you save? Or adding $1,000 to your emergency fund would put you into a better spot financially. Of course investing $1,000 today, adding $1,000 to it every year, staying invested for 30 years, and earning a 7% return is quite significant: it grows to $108,685!

Is the Latte Effect Important?

It is easy to take a shocking number like the one above and assume that the latte effect is always right. But some argue that the latte effect is only technically correct; that in practice focusing on this frivolous spending isn’t going to make you rich.

From a calculations standpoint, the latte effect is 100% correct. If you spent $4 per day on coffee, every weekday, for 50 weeks per year, for the next 30 years, you would miss out on over $100,000 in investment return.

That’s a lot of money.

At the same time, what if having your daily coffee – fancy or not – helps you feel sane so that you can work at your stressful job? Or what if you’re ahead on your other financial goals and this is how you treat yourself?

The bottom line is that everyone wastes money in some way whether through ignorant spending or happily hobbying. Whether or not the latte effect is important in your personal financial situation is dependent upon your situation. If you’re meeting your other financial goals and have room in your budget to spend on things that are important to you, who can really fault you? We can’t all live like hermits, away from the world, hording up our money and never enjoying it.

Do you agree?