Debt can cost more than you think: Understanding the Lost Opportunity Cost of Debt
It’s not always easy to see the real magnitude of how overspending and living in debt erodes wealth. People often focus only on saving, investing, and building wealth. They don’t realize that they are often losing much more wealth than they are actually building.
These losses come from paying taxes, fees, certain insurance costs, and monthly lifestyle expenses.
Perhaps the most damaging cost is maintaining credit and loan balances to finance things that are going down in value over time, like cars, TVs, furniture, appliances, etc.
When this happens, you lose in three ways. First, you lose the asset value because the asset you bought depreciates. Second, you lose the
payments because you agree to financing terms. And third, you lose the use of money on those payments ... forever.
This is known as lost opportunity cost.
What is Lost Opportunity Cost?
In personal finance, lost opportunity cost is a powerful and extremely negative force. When you lose a dollar, not only is that dollar gone, but you also lose what that dollar could have earned for you had you been able to keep it.
If you have the opportunity to earn 8% (say 5% after tax) in your investment portfolio, then every dollar you lose is a dollar that never gets to enjoy that 5% net interest.
Auto Loan Example
Let’s consider a typical couple with two cars parked in their driveway. They are nice cars, with all of the latest features that make them a hit when they pull up to a valet stand at the local restaurant.
One car has a monthly payment of $800 and the other has a payment of $600. That’s $1,400 each month coming off of their balance sheet … to finance cars that go down in value as the odometers go up.
Now, let’s further assume that every five years the old cars are traded in for newer models — that cost a bit more each time — and that this continues until this couple retires 25 years later.
The loss of wealth surrounding making car payments is staggering.
The combination of actual car payments and the lost opportunity on making these payments means that this couple will be missing $1,076,000 from their retirement nest egg. See chart 1 below.
If, however, this couple could lower their monthly car payments by 50%, they could “recapture” over half of what they were previously losing. This could easily be accomplished by buying less expensive cars, buying used cars, or simply driving cars longer before trading them in. The result is that they still have adequate transportation, but they are holding on to $700 each month. This simple step allows this couple to build over $500,000 of additional retirement wealth.
See chart 2 below.
A balanced perspective:
Thinking about your spending in the context of opportunity cost and your long-term financial future can help you determine if your purchase or expense is “worth it.”
To get a sense of the lost opportunity cost of the purchase you’re considering, ask yourself three simple questions:
• What is the true cost of this expense including interest?
• What is the potential for this money if I save or invest it instead?
• Is the item or experience today worth the loss of wealth in the future?
How to reduce the Lost Opportunity Cost of your debt
It’s clear that spending and living in debt create a substantial lost opportunity cost — but that doesn’t necessarily mean you should scramble to pay off debt as fast as possible.
Eliminating debt quickly can get in the way of your other more important financial priorities. If you apply a significant portion of your money toward paying down debt too soon, it could affect your ability to maintain Financial Balance®.
Consider these simple steps to reduce your debt and the drag of lost opportunity cost:
1. Consolidate your debt.
It’s easier to see the real cost of your debt when you pay your debts in one monthly consolidated payment. And, consolidating your debts into a single loan lets you pay less each month,allowing you to apply money to other areas in your financial life where it could make a greater difference.
2. Slow down your debt payments.
By paying down debts aggressively, you may be losing the opportunity to use that money in ways that can benefit you more — today and in the long run.
3. Apply this “found money” to bolster your protection, savings, and investments.
Once you’ve consolidated your debt and slowed down your payments, you’ve freed up money that can be used to ensure you’ll have maximum protection, help you save 15–20 percent of your gross annual income, and maintain proper levels of liquid savings.
By understanding the impact of the lost opportunity cost of your purchases and expenses and working to reduce debt over time, you’re putting yourself in a position to make the most of your money.
That’s common sense — with an uncommon perspective.
Hypothetical examples are not intended to suggest a particular course of action or represent the performance of any particular financial product or security.
Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. Guardian does not offer nor service automobile insurance. Trademarks of The Guardian Life Insurance Company of America (Guardian)
are used with express permission. © 2018 Guardian
Pub8161 2018-71332 Exp. 12/20