Why Learning What The Opportunity Costs Is of Your Money Can Be Critical

Do you know what opportunity cost of your money is? I recommend finding out, because the opportunity cost of money is so critical to every financial decision you make.

For example, if I offered to lend you money at 30% interest, how much would you take? My guess is none. If you did take any money, you’d make sure to pay it back as soon as possible.

The reason why is obvious—the cost of money is 30%.

But what if I loaned you the money at 0% interest—how much would you borrow then? When would you pay me back? Hopefully your answer is that you’d take as much money as possible and never pay me back, because the cost of money was zero.

Those were hypothetical scenarios, but the cost of money isn’t hypothetical. It affects every financial decision you make—even everyday purchases.

How the Cost of Money Affects Every Purchase You Make

Let’s say that you’re considering a vacation to Europe. Maybe Italy, Greece, Spain—and it’s going to cost you $5,000.

Well whenever you spend cash instead of paying down a loan, or instead of putting it in an interest-bearing account, there’s an additional cost involved. That trip may cost you more than $5,000.

Here’s how: if you’re paying 12% interest on a $5,000 loan, but you take a $5k trip to Europe instead of paying off the loan... then the trip didn’t just cost you $5k. It cost you $5,000 at 12% interest because the loan is not paid off.

Similarly, if you’re earning interest from a safe, consistently-paying source, say 5% from the Cash Value of a Whole Life Insurance Policy, and you choose to take a $5k Europe trip instead of adding that money to your Whole Life Insurance Policy, then, again, the trip cost you more than $5k. It cost you $5,000 at 5% interest because of the opportunity cost of not investing that money.

Every time you make a purchase, even small purchases, instead of paying off a loan or adding to a safe investment, there’s an extra cost to it: your cost of money.

Two Questions to Determine Your Cost of Money

Your cost of money is determined by two numbers. First, what is the highest interest rate that you’re currently paying on a loan? Any purchase you make is a payment you didn’t make to that loan, so the Cost of Money is that highest interest rate.

Second, what is your highest safe and highly predictable return on your money? (The stock market doesn’t count because it’s not predictable.) Any purchase you make instead of adding to this investment comes with an opportunity cost. So your highest safe ROI is the other side of your Cost of Money.

Don’t Get Carried Away

Clearly just because there’s an extra cost associated to every purchase does not mean that you should avoid purchases. The cost of money does not say that you shouldn’t take the vacation, but that there are more things to consider than just the cost of the trip.

I used to drive my wife crazy by calculating the cost of money on the glass of wine she just ordered at a restaurant. I’d tell her how much that glass of wine cost after 30-years of earning 5% interest instead.

I don’t do that anymore because it’s scarcity-minded. The cost of money should inform you, not paralyze you. So before making a decision on financing, paying something off, or where to invest—always think about the Opportunity Costs involved and use it as a guide.