Opportunity Cost: What Are You Giving Up?
Have you ever been struggling to decide between two options and thought to yourself, “If I choose option A, then I will miss out on the benefit of option B”. Maybe without even realizing it, you were using the principles of opportunity cost to make your decision. Most commonly, opportunity cost is used to refer to the literal dollar cost of choosing one option over another. This concept can also be applied to other aspects of your life, for example, time spent cleaning your house means that you can’t spend doing something else, say, enjoying a day at the beach. In this example, the opportunity cost of having a clean house is missing out on a day at the beach. Or if you were to choose a day at the beach, the opportunity cost of enjoying a day at the beach would be having a messy house.
As this term is most commonly used, choosing to place your money anywhere comes at a cost in terms of what you could have done with that money. If you have a stack of student loans at a high interest rate, one too many credit cards balances, or are hoping to save for any of life’s many milestones, you may be better off saving less and knocking down other debts before contributing much or anything to a savings plan. Each case is unique, but it is always important to look at all of your options when deciding what to do with your money.
Here is one example of how to think about opportunity cost in real life. We have all heard it’s a good idea to pay ahead on your mortgage if you are able to, right? Increasing the equity in your home can be a great financial choice, and can save you lots on interest in the long run, but before deciding if this makes sense for you, you should consider the opportunity cost of what else you might use that money for. If your mortgage interest rate is 4%, but you have a fairly low risk mutual fund that is earning 8%. If that’s the case, it might make sense to invest that extra money each month into the mutual fund instead of paying ahead on your mortgage. In this case, the opportunity cost of paying ahead on your mortgage would be losing out on the 8% interest you would have earned through the mutual fund.
Now it’s not quite as simple as just comparing the numbers, because in the example above, the mutual fund has some risk and the interest rate is never guaranteed. Conversely, if your mortgage rate is 4% and the best investment option you can find earns 3.5% interest, then it probably makes sense to use that savings to pay ahead on your mortgage, instead of increasing your savings. Again, it’s not always an all or nothing situation, it’s more about considering all of your options and making the choice that makes the most sense for your situation.
In practice, you want to do some of each. Putting some into savings and paying some ahead on your mortgage would allow you to have some funds set aside for when the furnace dies, or the roof needs to be repaired. If you pay it all ahead on the mortgage, then you would have to refinance or take out a home equity loan to make that money available for necessary repairs. If you put it all into savings, then you are paying 4% in interest when you don’t need to. Every choice we make has an opportunity cost, so important to find the right balance that makes sense.