One of the most basic principles of finance is the concept of opportunity cost. Simply stated, opportunity cost is whatever we give up when we make a decision regarding what to do with our money. Here’s an easy example: say we have some money in an investment account at Charles Schwab that is currently earning 8%. We could choose to take some of that investment account money and pay down our mortgage, which is at 5%. Should we do it?
With this limited information, logic would seem to dictate that we would not want to give up 8% in order to pay a debt at 5%. Why? Because we would literally be sacrificing the 8% return, leaving us 3% worse off. To be fair, there ARE reasons we may consider doing so (working to improve our credit score by reducing our overall debt, preparing to purchase a larger home in the future, etc)
Opportunity costs requires us to realize that, as we are considering financial decisions, ALL money has a cost associated with it, even when it’s coming out of our own pocket. The question is: what else could we do with that money? If the answer is that we could invest in a CD at 3%, then that becomes a cost we must consider in our financial decision-making.
Opportunity cost is the highest return we give up in making our decision. So when thinking about a variety of purchase or investment options, always consider what that money could be doing otherwise. As long as you consider your opportunity cost, the decision about what to do with your money is always up to you!