What are those big life decisions really costing us?

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As one of our daily tasks as adults, we have to make decisions- sometimes financial ones. And if you’re like most Americans, you will briefly weigh the options, perhaps even consult a spouse or a friend, and make the best informed decision.  But have you ever stopped to think about the other side of that decision?  The “what-if” of the alternative choice you could make and how this may even impact your financial future.

First, let’s understand exactly how the economic concept of opportunity cost could come in to play and why you should care.  Investopedia defines opportunity cost as the “benefit that a person could have received, but gave up, to take another course of action.”  So a very basic example of this is making a decision about where to stash your emergency fund.  Bank A is paying 1% for savings accounts and Bank B is paying 2% for certificates of deposit or CD.  You elect for the savings account for the ease of access to the money and the lack of a withdrawal penalty if you need the money.  The opportunity cost here is the 1% or the difference in the rates that you could have received by opting with Bank B’s CD.  Pretty basic concept, but let’s apply it to three examples that we may encounter.

Example 1- Addicted to that new car smell much? 

Congratulations, you just paid off that car loan and you’re ready to tell that bank “adios!”.  Then you are getting that oil changed at the dealership, and the service guy reminds you up that they are running a sweet deal on newer models of your favorite car.  Let’s assume that your current car will easily make it another 3 years with no major repairs.  Don’t factor in depreciation for this example, and assume maintenance/gas costs are similar for each option.  Another assumption is that you can trade up for $10,000 with financing at 4%, 3 years, roughly $300/month.  You had been planning to start a Roth IRA with that extra money from your recently extinguished $300/month payment on your current wheels in an index fund for the next three years that will perform at 7% annually.  Decision time!

 

Table 1 Cost Per Month Total Car Costs after 3 years 20 years from now
Option 1-Keep the existing car 3 more years $0/month payment (divert to Roth IRA)

$0

$27,266

Option 2-Trade for newer car now $300/month car payment

$10,800

n/a
Opportunity Cost of Purchasing

$11,674

$27,266

Source: thefiscalsavant.com

What does it really cost to trade?  If you said $11,674, you are partially right.  This is the opportunity cost, or what we gave up by buying the newer car, at the end of 3 years (the larger $11,674 amount is with the 7% growth compounding annually).  Setting up that Roth was smart and let’s say you decide to just leave that money alone and let it grow for another 17 years, assuming 7% growth with no additional contributions.  So the real opportunity cost, and you need to think longer term, is actually the value at the end of 20 years or $27,265.  The power of compound interest and time is certainly at play in this example.

Example 2- Got a 5% raise mid year because you are awesome at work apparently.

Look at you climbing that corporate ladder.  Time to celebrate right?  That raise can certainly raise your standard of living for you and your family.  But what if you used it as a chance to boost up that retirement savings (seeing a trend yet…?).  Some basic assumptions, let’s assume you make $50,000 after the raise and no additional raises for 5 years. Your options are you can either bump your retirement contributions from your current 5% to a whopping 10% or you can just decide to let the raise wander aimlessly into your checking account each month for a certain demise in the form of some needless spending.

 

Table 2 Retirement savings per month Total Value of raise after 5 years Total Value of raise after 20 years
Option 1-Increase retirement savings to 10%

$417

$29,833

$212,671

Option 2-Spend that raise

$208

$14,916

$106,333

Opportunity cost of spending

$208

$14,917

$106,338

Source: thefiscalsavant.com

So after the first 5 years, the results of our frugality have paid off handsomely, but let’s say we keep up the progress and leave our retirement contributions at 10% for another 15 years.  For simplicity sake, assume no raises (which I realize isn’t going to be the case) and 7% annual growth.  Now our decision payoff has hit six figures.  This doesn’t take into account what you may have already had in the retirement account, employer matches, future raises, or future contribution increases!

Example 3-Jonesin’ to keep up with those Joneses

This has become an expectation it seems like in segments of our societies.  Our house is no doubt a very important investment and for most younger folks represents the largest investment they have made so far in their life.  And trust me, banks will let you spend plenty with what I think are very frothy approval standards for your income.

So you’ve found two amazing houses.  They both serve your needs, they are located in nice neighborhoods. But one can be bought on the cheap from a motivated seller for $200,000 and the other is bigger and much fancier for $300,000.  You have been frugally bustin’ your hump and you have the 20% down payment for either house plus you qualify based on your income.  Let’s say in this example, you plan to put the rest of the down payment and the monthly payment savings into a brokerage account making 5% annually if you go smaller.  Pressure is on, this one is a nothing to take lightly.

 

Table 3 Financed Amount Down Payment left to start brokerage account Monthly PITI* 5 year Brokerage Balance
House 1-$200,000 PP

$160,000

$20,000

$1,097

$63,158

House 2-$300,000

$240,000

$0

$1,646

$0

Opportunity Cost of larger house

$549

$63,158

Source: thefiscalsavant.com

*Financing assumes 30 years @ 4%, 20% down, no mortgage insurance. Taxes/homeowners insurance at 2% of property value.

This should be an eye opener.  In a relatively short time frame, we were able to invest the down payment and the difference in PITI by selecting the cheaper house and amassed a solid $63,158.  Think of the options and doors that money could open up and this doesn’t factor the higher cost of utilities that comes from owning a larger house.

These examples aren’t perfect and I realize we could add this factor or consider that piece of the puzzle. And I get it, there is a human side to making major life decisions.  It’s not always about the financial perspective.  But if you’re like me, this is big money and it gets the wheels turning as to how you may approach that next major purchasing decision or windfall.  Make sure you are considering every angle and if you are not using some form of a budget or a plan, start now.  You’ll be glad you did.  Email us if you have questions or comments or need help understanding where the numbers came from!

-The Fiscal Savant-

*Disclaimer-The information contained within is the opinion of the editor and should not be construed as financial advice.  Enjoy our articles for what they are and consult with financial professionals for tax and investment advice.


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