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How Much Does Opportunity Cost?

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Opportunity Cost

Whether you realize it or not, you generally take opportunity cost into consideration whenever you decide how to manage your time, money, or debt. Because most of us have limited resources of time and money, we generally want to use our time wisely and get the “biggest bang for the buck.”

Opportunity costExample: You can stay home and study for tomorrow’s exam or go out with your friends. You have a choice to make. Is the opportunity of a night out worth the cost of poor test results?

Here’s another example: You can go straight to work after high school at a low wage job or enroll in trade school, college, or university to acquire the training you need for higher paying work. Is the opportunity of post-secondary education and potential future earnings worth the cost of two to four years of lost wages and student debt?

Balancing scarce resources of time and money — in an effort to optimize outcomes — also applies to debt management. It’s always a good idea to pay off credit cards and other high-interest debt first. Instead of paying 12-18% interest on your credit card, you could be paying yourself. The question now is should you pay off all your debt as quickly as possible? Or could you put your (scarce resource of) money to better use?

The answer depends on two things:

  • The cost of money. How much interest are you paying on your student and/or home loans? As of this writing, most of these loans are charging under 5%.
  • Opportunity investment. What alternative uses do you have for the money that you would use to pay off your loans?

Consider the following example. You have a choice. You can use your money to pay off your student loan more quickly, or you could invest it. What should you do? The answer is pretty straightforward. Apply your money toward the highest interest rate.

  • If you’re paying 4.0% interest on your student loan and you can invest your money at 6.5%, then invest.
  • If you’re paying 7.5% interest, you can save money by paying off your loan more quickly. When you pay an extra $50, $100, or $200 a month, you can save thousands of dollars in interest expense by shortening the life of you loan.

Emotion often overrules reason, which isn’t necessarily a bad thing. The psychological effect of paying off your low-interest student loan may outweigh the practical benefit of optimizing your investment return. That’s why the cost of opportunity always involves a choice, which only you can make.

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About Steve Lome

Steve Lome and Dave Kramer are the guys behind "The $500 Cup of Coffee, a Lifestyle Approach to Financial Independence, Especially for Millennials and the People Who Love Them". We are not professional financial advisors, but we have lots of money experience. As a mortgage broker, Dave reviewed the personal financial statements of thousands of customers. As a developer of affordable housing, Steve learned it was easier to build a house than a mortgage-ready customer, because so many of his prospects were wearing or driving their wealth. They both realized that no matter how little or how much people make, most do a lousy job of managing their personal finances. Dave first conceived of “The $500 Cup of Coffee” as a way to help his clients save their money. Working with Steve, he re-imagined it as a roadmap to financial independence that almost anyone can follow. The final result is a well-balanced blend of Dave’s straight forward thinking and Steve’s expansive worldview that encourages a commonsense, relatively low pain approach to wealth accumulation, emphasizing conscious consumerism, steady saving and regular investing.