The Opportunity Cost of Spending

This is not actually a popular topic- most people don’t like to discuss this, because, well, it makes spending money less fun. It’s really important though, and I believe that of the critical financial tenants I learned early, this may be the most important.

Here’s an example: Katie and Joe are in the market for a new house. Based on their current financial picture, their incomes, and current interest rates, they figure that they can afford up to $380K and feel comfortable with the payment, insurance, and taxes. This budget allows them to live in a desirable school district and safe neighborhood, and affords the square footage they need and even the luxury of a pool. Awesome!

But when you look at purchases like an accountant, every dollar that is spent (or is obligated to be spent, like a mortgage payment), carries an equal and opposite debit on the ledger. Every dollar you spend has an opportunity cost in the form of a dollar not saved. I use this opportunity-cost analysis to make virtually every major purchasing decision. As we’ve discussed in previous posts, being “able” to afford something because you can cover the payment, and wanting to afford it because it’s worth the long-term deficit in your savings, are two different things.

When analyzing Katie and Joe’s house purchase decision- the monthly payment for the $380K house is about $1800 when considering mortgage, local taxes, and insurance. But if they could find a house they like in the $325K range, that payment is closer to $1550 per month, saving them $250 per month. It doesn’t sound like much, but if they invested that $250/month from now (age 30) until retirement at 65 and yielded an 8% return, they would have an additional half a million dollars in their retirement account- pretty hefty for a $250/month sacrifice!

There are a lot of little windfalls that get blown through because they don’t seem like huge amounts of money at the time- a small inheritance, a big bonus at work, etc. But if you look at the opportunity of investing that long term, it’s huge. $10,000 at the age of 35 becomes $100,000 at the age of 65. If you’re 25, it’s a whopping $217,000 by retirement. How valuable is that thing you want to spend it on today? Is it worth not having almost a quarter million dollars later?

A $10,000 raise at the age of 30, if invested annually until retirement at 65, becomes nearly $1.3M. Can you keep your same house payment and car payment for now, in exchange for over a million dollars when you’re retired?

If you follow this practice to the letter in everything, you will literally never, ever spend any money on anything. I’m not advocating for that, I promise. But when you are faced with a large (or sometimes small) purchase, at least take a moment and just think about whether the proverbial bird in the hand outweighs the two in the bush. Your future self will thank you.