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Splurging or Saving? The Gen Z Luxury Dilemma and the Power of Compound Interest Unleashed

Post on March 30, 2023 in Blog

A recent CNBC study revealed that Gen Z is now the driving force behind luxury spending in the United States, and that trend doesn’t appear to be slowing down. In fact, Gen Z’s purchases are expected to grow at a rate three times faster than those of older generations in the coming decade. 

This luxury boom is fueled by a variety of factors, including increased affluence due to the fact that 48% of young adults are still living with their parents and the skyrocketing influence of social media. Unfortunately, it’s also due to an increased reliance on credit card debt to buy said luxury goods, according to a new report by Credit Karma.

While purchasing luxury goods is not inherently irresponsible, doing so at the detriment of your future is not wise. 

Today, we’ll be looking at what you can do to secure your financial future prior to making a luxury purchase. We’ll also explore what Einstein referred to as the eighth wonder of the world—compound interest—to demonstrate the importance of investing early. 

Key Takeaways

  • Gen Z is driving luxury spending in the U.S., but this trend comes with increased reliance on credit card debt.
  • While indulging in luxury items isn’t inherently reckless, it could be at the expense of your long-term financial well-being.
  • Building a strong financial foundation prior to making luxury purchases is vital, and that includes paying off high-interest debt and investing for the future.
  • Compound interest can significantly grow investments over time, making it crucial to start investing early in life.

The Power of Compound Interest

Compound interest is the process by which interest is reinvested and added to the principal amount, resulting in the potential for earned interest on both the original sum and any accumulated interest, creating a snowball effect. This can be hugely beneficial for young investors because of the power of compounding over long periods of time, especially when compared to simple interest.

Read more: Investing for College Students: The IRA Edition

Simple vs. Compound Interest

Simple interest is calculated only on the initial principal amount, whereas compound interest is calculated on both the initial principal and any accumulated interest, leading to exponential growth over time. Let’s look at two examples, which demonstrate the differences between simple vs. compound interest:

Simple interest is often used for short-term loans. For example, a personal loan with a principal amount of $10,000 at a 6% annual interest rate for two years. In this case, the simple interest would be calculated as follows:

Simple Interest = Principal × Rate × Time

Simple Interest = $10,000 × 0.06 × 2

Simple Interest = $1,200

Total amount owed = $11,200

Compound interest, on the other hand, is frequently used for long-term investments and savings accounts. For example, a savings account with an initial deposit of $10,000 and a 4% interest rate, compounded annually for 30 years. In this case, the compound interest would be calculated as follows:

Future Value = Principal × (1 + Rate)^Time

Future Value = $10,000 × (1 + 0.04)^30

Future Value = $32,433.98

Unfortunately, credit card debt is also subject to compound interest, and the majority of credit card issuers compound interest daily. That’s why it’s essential to be mindful of your spending habits and prioritize paying off balances promptly to prevent debt from snowballing and negatively impacting your financial well-being.

Simple vs. Compound Interest

Source: Finance Strategists

Buying Luxury Goods vs. Investing

Now that we’ve established the power of compound interest when it comes to investing (and credit card debt), as an example, let’s compare purchasing a $5,000 luxury handbag and, instead, investing that money.

Luxury Handbag vs. Investing

While a luxury good may provide immediate satisfaction, its value is likely to depreciate over time. According to a recent CNBC article, Louis Vuitton’s average retention value at resale is 92%. So, unfortunately, it’s unlikely that your handbag is an “investment piece,” even if that is your justification for the purchase.

However, investing $5,000 with a 12% return, compounding monthly, would grow to approximately $179,748.21 in 30 years, thanks to the power of compound interest. This substantial growth demonstrates the long-term benefits of investing, especially if you start early. 

Plus, if you invested the initial $5,000 using a Roth IRA, your gains would be completely tax-free, assuming you wait until you’re at least 59 ½ years old to take distributions. 

Read more: What’s the Difference Between Roth & Traditional IRAs?

Balancing Enjoyment and Financial Security

Before making luxury purchases, you should consider whether you have a strong financial foundation to ensure you can afford and enjoy your purchases without compromising your long-term financial goals. 

Here are some key financial aspects to consider:

  1. Create an emergency fund: Establish an emergency fund with at least 3–6 months’ worth of living expenses to cover unexpected situations like job loss, medical emergencies, or car repairs.
  2. Pay off high-interest debt: Before purchasing luxury items, make sure you’ve paid off high-interest debts such as credit card balances or personal loans. These debts can quickly accumulate and hinder your financial progress for years to come.
  3. Set savings goals: Set aside money for short-term and long-term savings goals, such as purchasing a home, starting a family, or funding a college education. 
  4. Consider your long-term investments: Contribute to your retirement account(s), such as a 401(k) and/or an IRA, to ensure you are on track for a comfortable retirement. 

Diversify Your Portfolio With Alternative Investments

We’re all for using your money to create a life you love. After all, one of our core values is “You do you.” However, ensuring your financial wellness is in order before making a luxury purchase will help you maintain a strong financial foundation. 

In addition to traditional investments, you may consider investing in alternative assets to diversify your portfolio. Alto gives you access to a wide range of investment options, including startups, real estate, fine art, and more, ultimately adding one more tool to your overall financial wellness toolkit—not to mention, giving you the opportunity to invest in assets you’re interested in. Create an account today to get started.