Are you missing chances to build your economic prosperity effortlessly? Unfortunately, many people are, simply because the financial industry does not talk about opportunity cost enough. It’s treated as an abstract concept rather than one that actually has a tangible impact on your wealth! Today, we’re answering the question: What is opportunity cost?
It begins with the third of the Prosperity Thinkers’ 7 Principles of Prosperity, which is to MEASURE your opportunity costs. Once you learn to think prosperously and see the big picture of your personal economy, you can then measure where prosperity may be “leaking” out. Once you identify your money leaks, you can then plug the holes! Measuring potentially lost opportunity costs will help you accelerate your prosperity with simple changes.
Opportunity Cost Definition
To understand opportunity cost, we first have to define opportunity cost.
Opportunity cost is the money you “lose” by spending your money elsewhere. For example, if you spend $1,000 on a shopping spree, you don’t just lose $1k. You also lose the opportunity to do anything else with that money. For example, you can’t earn money on that $1k by putting it into a CD. Say you saved that money into an account earning 5%. In a year, that might not be much of a cost to you, yet over 30 years, that 5% could mean quite a lot to you. In the opportunity cost calculator below, you can see that money would have grown to over $4,000.
The thing about opportunity cost is that once you spend a dollar, you lose the ability to save or invest that dollar for the rest of your life. You may earn new money, and choose to invest that new money, yet you’ll never recoup the opportunity to invest that original $1,000. So, you’re not simply losing the dollar at face value, you’re also giving up that dollar’s potential for the rest of your life.
Is Opportunity Cost a Real Cost?
The problem with opportunity cost is that the concept is treated almost as if it’s a unicorn. In other words, it’s treated like a myth within many financial circles. Yet with any opportunity cost calculator, you can prove that it has a real impact on people’s finances. It may feel intangible to you, yet the deeper you go into your financial decisions, the more real it becomes.
One of our favorite examples to demonstrate this is to calculate the opportunity cost of buying a car. When you pay cash for a large purchase like a car (or a home), you may think you’re saving thousands of dollars in interest. And while you may be saving an interest payment, there’s still a cost…the cost of interest you could have earned. In most opportunity cost calculations, one thing is clear: paying in cash doesn’t make you better off.
In fact, if you want to have an emergency/opportunity fund, it’s often more advantageous to take a loan and save or invest money along the way. This can reduce your opportunity costs by millions of dollars over your lifetime, and plug your financial “leaks.”
How to Find Opportunity Cost
Finding opportunity cost is simple enough, with the Future Value calculator from Truth Concepts. It’s not something you can demonstrate on paper, because you’ve got to account for all the years of compounding interest that your initial dollar amount will accumulate. In Year 1, your thousand dollars may only grow to $1,050. Yet in Year 2, you’re earning 5% on $1,050 not just $1,000.
With the Future Value Calculator from Truth Concepts, you can show how much something will grow at a particular rate, over a particular timeframe. So if you want to know the opportunity cost of paying cash for your $25,000 vehicle, you can. In this instance, let’s demonstrate it over 7 years, which could have been the term of a car loan. Let’s use 5% again. As you can see, that $25,000 had to potential to grow to over $35,000 in 7 years.
This isn’t to say you shouldn’t spend money. However, it’s a reminder to think carefully about your purchases and consider that sometimes paying cash isn’t the best option. If you’re not convinced, let’s look at how opportunity costs can impact your lifestyle.
Financial Decisions and Their Opportunity Costs
Below are five common places many people fail to measure their opportunity costs. By learning to measure your opportunity costs and strategize accordingly, you can increase your savings and liquidity by millions over your lifetime.
1. Your Lifestyle
When billionaire investor Warren Buffett was offered a glass of expensive wine (brought by Malcolm Forbes) at a VIP birthday party for a friend, he told the server, “No thanks, I’ll take the cash.”
His sense of humor aside, Buffett’s frugal sensibilities are well known. Living in the same middle-class neighborhood home for decades and even getting married in a simple civil ceremony at his daughter’s home, Buffett sees every dollar as a potential seed to grow more dollars. Many people could benefit from “living like a billionaire” with Buffett as their role model.
No, we’re not saying you can’t have the avocado toast once in a while. However, it’s a wise lesson to balance what you want with what you can save. That way, you’re building liquidity for the things that are really going to matter to you in the long run. Just be sure to actually tuck that money away!
2. Your Mortgage
Perhaps you’ve got a 15-year mortgage, and you’re trying to “pay a little each month” on your principle. Maybe you’re following one of those bi-weekly payment plans to accelerate paying off your mortgage. It sounds great on the surface. You’ll build equity and own your house faster…right?
The problem with this philosophy may not be obvious until a financial advisor reveals the impact of lost opportunity costs with software that calculates the results. Since a home’s value increases (or decreases) at the same rate regardless of the mortgage balance, the money used to “pay down the principle” can usually be used more effectively elsewhere.
In fact, taking a 30-year mortgage and saving the difference into an optimized account like whole life insurance can help you recoup most of the opportunity costs. You’ll get the extra benefit of protection for your family!
3. Insurance Premiums
One reason we are fans of Whole Life insurance is that your premiums do not become “lost opportunity costs” at the end of the day. Quite the contrary, by learning how to multiply your money with Whole Life, opportunity costs can become opportunity gains as your money is allowed to multitask. For example, you get the income and life protection of the insurance, the liquidity of the cash value, and the tax advantages of the policy loan. Plus, the policy loan helps you to leverage your money without withdrawing it, which means it continues to earn interest and dividends. The result? Minimized opportunity costs because you can use your money AND earn a return on it at the same time. How many other assets can boast that feature?
In many instances, we also find that it makes sense to raise deductibles to lower your premiums on property and casualty insurance. This can help you accelerate what you’re able to save each month, and therefore earn on those savings.
4. College Funds
Many parents start saving for their children’s college when they are very young, or even before they are born! However, a 529 plan can serve to “lock up” money that can be used elsewhere. We help our clients evaluate whether there might be better ways to save this money—and have even more liquidity and options when college rolls around.
5. 401k or IRA
In many situations (such as when you’re not receiving a “match” from your company), it doesn’t make financial sense to isolate a portion of your money for a single purpose and lose the opportunity to invest it elsewhere. Especially not when there are penalties, taxes, and management fees just to accumulate and use the money. You may technically be earning a rate of return over time, yet there can be a major opportunity cost to any losses in your account. In fact, it can take YEARS just for your account to catch back up to its original value after a loss. Talk about opportunity costs!
Why is Opportunity Cost Important?
The fact is, most “financial planning” is focused on retirement, which may be decades away. It doesn’t factor in opportunity costs and does you a major disservice. By learning how to measure your opportunity costs and adjust your strategy accordingly, you can put millions of dollars back in your pocket over your lifetime.
Our approach (Prosperity Economics™) helps you develop a strategy for the future, but also looks at how you can optimize your personal economy right now. We do this by identifying where money is being “lost.”
Once you understand that concept of measuring opportunity costs, you will apply it to every financial decision you make. When you incorporate them, you can sometimes recover them… and get back the lost opportunity!
If we can help you get started, or you have any questions, we invite you to connect with us, or email us directly at firstname.lastname@example.org.