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.”
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.