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What Are Opportunity Costs? – Textbook Personal Finance

Every financial decision has an opportunity cost. What is an opportunity cost? It’s the trade-off of making a decision.

Sometimes the cost is financial, sometimes the opportunity cost of a financial decision spills into other areas of our lives.

Example of a Financial Opportunity Cost

For example, if you empty your savings account to pay off a car loan, you’re saving yourself all the money you’d have spent in interest. You will also get to save the money you’ve been putting toward monthly car payments or apply it to another debt.

The trade-off is that if you have an emergency, you won’t have the financial cushion to absorb it. You also won’t earn any interest on the money in the savings account. By making the choice to pay off your car, you’ve given up a certain measure of financial security and the interest you would have earned.

So does keeping the money in the savings account save you the opportunity cost? No, there’s always a consequence, a trade-off for our decisions–personal and financial.

Were you to save the money, then you’d have the ability to deal with an emergency and you’d earn interest. But you would have a monthly drain on your finances and would continue to pay interest on the loan. It’s likely that the loan’s interest is greater than the money you’re making on the savings account.

Example of a Personal Opportunity Cost

Choosing to go into debt in the first place—whether for an emergency, for an education, for a car, or for a new tv—has a personal opportunity cost. Besides designating part of your money for debt repayment vs. savings/investment/fun stuff, it limits your freedom until the debt is paid.

Take student loans, for example. A law student at a higher-end law school graduates with an average of over $100k in student loan debt. Suppose the newly-minted lawyer wants to represent poorer immigrant communities doing primarily pro bono work. Even though she may be able to draw a small salary from an endowed institution which provides pro bono legal services, one he could normally live on, it might not be enough to live on and pay back student loans.

Therefore, the lawyer takes a better-paying position at a firm doing work that she’s not passionate about. After she pays back the student loans, it may be possible for her to do the work she’d set out to do—or she may have acquired new debt in the meantime and still find herself locked into a job she dislikes.

If the lawyer eventually decides to take a job with a low-paying salary in order to do work she’s passionate about, it will cost her the ability to live in an expensive house, drive an expensive car, and go on nice vacations. But for her, the price may be worth it.

Are Opportunity Costs Bad?

Opportunity costs are everywhere in our lives. Most of the time they’re small enough we don’t think much about them. By writing this post right now, for example, I’m giving up time that I could be spending writing fiction or doing consulting work. But that’s ok because I want to be writing this post.

So no, opportunity costs themselves neither inherently good nor bad, they’re just the consequences of our actions and every action has a consequence. What’s important when making big decisions—such as attending a high-cost institution and taking out student loans—is to spend time considering all the foreseeable costs and whether they’re a price you’re willing to pay.

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January 16, 2010 at 5:47 pm
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January 17, 2010 at 8:14 am

{ 4 comments… read them below or add one }

thriftygal@chasingprosperity January 15, 2010 at 11:48 am

Oppotunity costs are inevitable. It’s up to you to decide the best option for you with the least opportunity cost.

Ken January 16, 2010 at 7:42 am

This is so true. We need to assess what we spend on and determine what the better choice is. What bothers me is how much by money could be earning me if I didn’t have to service so much debt. I will continue to attack debt and one day my money will earn me interest instead of the banks. Good post.
.-= Ken´s last blog ..Money Secrets? Spill the Beans =-.

Pastor Jim Kibler January 16, 2010 at 3:54 pm

I would say that if the interest rate is high such as a credit card it should be paid off but if the interest is low keep your cash or at least part of it.
.-= Pastor Jim Kibler´s last blog ..links for relief =-.

Red January 17, 2010 at 1:05 am

So true! I’ve taken out so much money in student loans that there’s no way I could pay back my loans while working for a newspaper, which is what I initially wanted to do. Now, I’m having to plan on taking a job at a place I don’t care for to earn enough to pay back my loans. ::sigh::
.-= Red´s last blog ..Week of spending =-.

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