Wise financial planning requires that you consider all relevant costs before making any major purchase. While most people consider the common costs associated with their capital investments, there is one cost that many overlook -- the opportunity cost of a major purchase.
Commonly Recognized Costs
The exact costs that must be taken into account depend on the particular type of purchase being made. Most people take into account all direct expenses, though.
For example, people know to evaluate purchase price, monthly payment and paid interest when buying a house or car. Many even recognize that maintenance, taxes and insurance also will have to be paid.
Few people consider beyond these direct expenses, however. That’s why many miss the less direct opportunity cost.
Opportunity Cost Examines Future Potential
Calculating opportunity cost puts the money spent on a purchase into a broader perspective, most often one of time. Only when the future value of money is taken into account can a purchase’s financial advisability be comprehensively evaluated.
In other words, opportunity cost looks at what else you could do with the money -- especially if you saved it for use later. Because funds typically gain interest over time, the total cost of a purchase is usually much higher than what only the above-noted expenses show.
The Opportunity Cost of a New Car
Consider the following example of someone who needs to purchase a car. They have $50,000 in savings and will be spending $30,000 upfront on a brand new car.
That $30,000 becomes a much higher expense once the opportunity cost is taken into account, even if assuming a modest 5 percent interest:
- If the driver keeps this new car for 3 years and trades it in, the lost interest during that period would be $4,728.75.
- If the driver keeps the car for 10 years, the lost interest becomes $18,866.84.
- If the driver is 40 years old and the total lost interest until retirement is taken into account, the opportunity cost becomes $71,590.65.
The person in this example likely can’t go without a car, but they don’t necessarily have to get a new one. Spending only $15,000 on a quality preowned vehicle would greatly reduce the amount of lost interest.
Opportunity cost doesn’t just have a large impact on the total expense, but it’s the largest expense when considered over a person’s life. Not considering it results in failure to accurately and completely evaluate a major purchase’s expense.
How to Calculate Opportunity Cost
Calculating opportunity cost requires tabulating compound interest, and that’s most easily done with an investment calculator. Enter your purchase price, time period and assumed rate of return, and an investment calculator will show how the opportunity of lost interest adds up.
Consider all of the Costs
Before you make another large purchase, consider all of the direct and indirect costs -- including opportunity cost. We go into greater detail about opportunity cost in our Financial Foundations program. Register for the next class and learn how to maximize your money.