Opportunity cost of money is value of an option that must be given up for alternative option
You don’t need to be a Chartered Accountant or have an MBA in Finance to acquire basic finance sense. But what does basic finance sense entail? The following concepts will give you some understanding.
Time value of money
In a nutshell, time value of money is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
Here’s a real life example. Suppose you have an apartment that you want to sell. Your buyer offers you Rs 50 lakh for it. But you are not happy with the price and think that it could fetch Rs 52 lakh instead, and you are willing to wait for it. You wait and wait and after one year, you finally find a buyer who buys it from you at Rs 52 lakh. You are in self-congratulatory mode thinking how a little patience has paid off. But has it?
So is 52 lakh now really higher than Rs 50 lakh a year ago?
Let’s examine. Suppose you would have decided to sell the flat at Rs 50 lakh a year ago. You could have invested that money in a fixed deposit at 8% p a interest. That would have earned you interest of Rs 4 lakh in a year. So now, that money would have become Rs 54 lakh versus Rs 52 lakh that you got. (Even if you assume the highest taxation of 30% on this interest, you would have still ended up with Rs 52.8 lakh). And if you manage to earn more than 8% return via savvy investment in stock markets, you would have ended up with even more money.
Opportunity cost of money
Opportunity cost of money is value of an option that must be given up for alternative option.
Suppose you have a home loan with an interest of 8.5%. At the year end, you get a handsome bonus of say Rs 5 lakh. Your wife urges you to pay off the home loan with this money and save all the interest that the bank is charging. You think to yourself, that by paying off your home loan by Rs 5 lakh, you will save the interest outgo of Rs 42500 per year (calculated @ 8.5% interest rate) thus reducing your annual EMI outflow by that much amount. What a brilliant idea!
But is it so easy? Let’s examine.
Suppose you decide to invest the Rs 5 lakh that you got as a bonus instead of paying off your home loan. You are stock market savvy, and confident that you could earn at least 10% return relatively risk free on your investment (you can earn more). So at the end of the first year, you will earn Rs 50000 as return. Assuming you paid LTCG tax of 10% on it, you are left with Rs 45000 in your bank. That’s the opportunity cost of the bonus money had you used it to repay your home loan.
It gets more complicated if you had been claiming tax savings on home loan and principal payments. If due to this repayment your principal outgo in the year goes below Rs 2 lakh or your interest payment goes below Rs 1.5 lakh, you will lose the tax benefit on those differential amounts. So it’s possible that your net savings is less than Rs 42500 due to the loss of tax benefit that you would have otherwise claimed.
So you see, you are better off by at least Rs 2500 (and may be more by factoring in the loss of tax benefits) by not paying off the home loan and instead investing in the stock market.
Sunk cost is the cost that has already been incurred and cannot be recovered.
Suppose you have a flat that you can rent. You think the fair rental for this apartment is Rs 25000. But all the offers that you are getting is Rs 22000. You believe in virtue of patience and if you can hold out for another couple of months, you will eventually get the desired Rs 25000 in rent.
You wait and after 4 months you get a tenant who rents your apartment for Rs 25000. You are over the moon at your financial tenacity. So was it really a financially smart decision?
If you would have rented your property 4 months ago at Rs 22000, you would have made an annual rental income of Rs 2,64,000 (22K times 12 months).
But when you decide to wait for 4 months, your apartment remained idle for 4 months, a loss of rent known as sunk cost. So, in a year, you earned rental income of Rs 2,00,000 (25K times 8 months).
So as far as the first year goes, by chosing to let out your flat at Rs 22000, you actually earned Rs 64000 more.
What about 2 years earning?
Assuming you are able to increase rent by 10% after 1 year. In the first scenario, you would have earned Rs 2,90,400 (Rs 24200 times 12 months) in second year. So your two year rental income would have become Rs 554400.
In the second scenario, you would have earned Rs 3,30,000 (Rs 27500 times 12 months) in the second year and your two year rental income would have become Rs 530000.
So you see, even over a period 2 years, by renting a flat at Rs 22000, you would have made Rs 24400 (Rs 554400 - Rs 530000) more.
So lower rent option makes more money overall because higher rent option involved four months of sunk cost when your flat did not earn any rent at all.
Fallacy of free - Invisible cost
All these years, you have been taking your own car to work. Now you are thinking the option of instead taking an Uber to work.
Your bestie argues why spend money on Uber when ride in your own car is almost free of cost. But think again, is there really a free ride, even in your own car?
There are multiple fixed and variable costs associated with the car ownership.
First, there is cost of fuel for the trip. That’s a relatively simple calculation involving the distance of the trip, cost of fuel and the mileage of your car. But wait, if you were to do that and stop there, you may still find that trip in your car may come to cheaper than the ride in Uber. But that’s not all the costs.
If you have taken a loan for the car, there is an EMI payment which you will have to incur whether you use your car or not. Even if you have self-financed the car, there is potential opportunity cost of that money. On top of that your car’s value is depreciating every day and that’s another cost. There will be annual maintenance costs. All these costs are invisible to the immediate trip but if calculated and allocated to the trip, they add a significant amount to your trip cost.
In more cases than not, you will find that actually using your own car is expensive versus the Uber ride. It’s not free, it’s more expensive.
So you see, selling your apartment at lower price, not paying off home loan to save on interest, letting your apartment at a lower rent or even choosing to commute by taxi over your own car are real life decisions that may actually turn out to be better financially under some conditions. All you need is a little common finance sense to be able to evaluate and come to the right decision for you.(The writer is Head of Business Development & Strategy at Equifax)