Opportunity cost
When we have to decide between investing and paying off debt, we have to give up the next-best alternative. For example, if we decide to pay off or pay down credit card debt, we give up an opportunity to invest the same amount.
In this case, the interest that we could have earned on the investment is the opportunity cost of paying off debt.
Opportunity cost is an important economic principle that affects the value of our financial decisions. For example, if we make a $1,000 payment on a 12% credit card, we can lower our interest expense. For one month alone, we save $10 in interest ($1,000*0.12/12). However, in order to pay down this debt, we may have passed up an opportunity to earn a 5% annual interest rate in a CD or other money market account. The opportunity cost, in this case, is $4.17 ($1,000*.05/12) in interest income.
Subtracting the opportunity cost of $4.17 from the debt savings of $10, we obtain a net savings of $5.83.
The following calculator can be used to illustrate this example:
Should I pay off debt or invest in savings?
Enter $1,000 in the first and fourth boxes, 12% in the second box, 1 in the third box, and 5% in the fifth box. Enter a zero in the last box, and view Results. The calculator shows that you save $10 for the one month. However, you also have an opportunity cost of $4, rounded to the nearest whole number. As a result, your net savings are $6.
To calculate opportunity cost, it's important to evaluate the next-best alternative. To do so, rank your decisions in order of importance. You will obviously use any extra savings to take care of the item at the top of the list. The second item on the list is the next-best alternative.
Opportunity cost is an important concept in financial decision-making. Here's a useful rule of thumb for incorporating opportunity cost into your financial decision-making:
If you face a spend-or-invest trade-off and decide to pay off debt, subtract the income you could have earned on the investment to calculate a net savings. If you decide to invest, subtract the interest you could have paid off on the debt to calculate net savings.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
