For the average person reading this heading, the opportunity cost of money might not make any sense at first. But understanding the opportunity cost of money will give you the insight needed to help you think twice before you buy or spend and, in turn, help you control your finances. Understanding the opportunity cost of money will help you make better financial decisions on your path to financial independence.

Choices you have with money

Every day we face choices with money, and the two main options we have regarding our money are either to spend it or invest it. Most people spend frivolously, as we are influenced by society and media in the consumption-driven age we live in, making it harder to save and invest. Understanding that there is a cost involved when spending frivolously will make you a better investor. This is where opportunity cost of money comes in. 

What is the opportunity cost of money?

It's the value of what you could have earned on your money when you spent it on something else. Think of it as what you could have earned on the money you spent if you had rather invested it. All of these foregone earnings are opportunity costs.  As your spending on unnecessary things increases, your opportunity cost will increase too. At Finsights we want to keep our opportunity costs to a minimum, meaning you don't spend unnecessarily and we maximise our investments to work hard for us.  

Examples of opportunity costs: Let's say an investment generated 20% returns last year, but you spent R50 000 on holiday the December prior. That means you had an opportunity cost of R50 000 times 20%, which equals R10 000. Next year, your cost of R10 000 grows by another 20%, meaning that in year two, your cost of that holiday goes up to R12 000. 

Let's use another popular example: Buying expensive cars. Person X buys a R450 000 car and agrees to repay the car in 5 years at a prime rate (11.75%) Your monthly instalment is R10 048.95, and your interest over this period is R151 729.64. Adding the purchase price plus interest means you spent R601 729.53 on a car that will lose at least 40% of its value in the first 5 years and will be worth R270 000 once it's repaid. 

If the car instalment (R10 048.95) per month was invested at a growth rate of 10% per year, your investment would be worth R778 161.27 over the next 5 years. This means your opportunity cost for buying the new car is what you could have in savings (R778 161.27) and what you have in car value (R270 000), which is a whopping R508 161.27 loss of opportunity cost.

How to think of opportunity costs

Adding a real number as an opportunity cost to every Rand or R10 000 you spend will make you think twice before you spend on unnecessary things. Your money is a worker that you employ to make money for you while you sleep or go about your day-to-day business. Money is the hardest worker out there, never taking leave, working 24/7, and never going on strike, which makes money as a worker very reliable. Knowing that your money can work for you means that one day you can work less for your money. We want you to employ as many money workers as possible. This is how you should think about the opportunity cost. 

How to calculate your opportunity cost of money

Think in terms of the stock market: Choose a long-term ETF or mutual fund that you currently invest in or would invest money in. Let's use the Satrix MSCI World Equity Index Feeder Fund as an example. This fund has a 10 year return of 14.26%. If you spent R10 000 unnecessarily, then your opportunity cost is 14.26% of R10 000, which is R1 426 missed out on every year. Remember, just as investment compounds, so do costs. If you spent your money investing in this fund, you would start employing extra money workers, and the R1 426 would be your first worker. In 10 years, your spend of R10 000 could have been worth R37 926.45, or it can be seen as a loss of R37 926.45 as it was spent on unnecessary things. See how you have the power of choice.

Think in terms of home loans: Another way is to think in terms of your home bond savings. Let's use a scenario where you have a bond of R1 million. At current interest rates of 11.75% your monthly repayments will be R10 837.07 per month for 20 years. 

Monthly repayments can be reduced by capitalising the R10 000. If you had invested the R10 000 into your property and capitalised it, your monthly repayments would reduce to R10 729 per month. This means your R10 000 spend is worth R108 per month for the remaining term of the bond.

Summary

Next time, before you spend money on items you don't need, ask yourself, What's the opportunity cost of these items? The more we spend on unnecessary items, the bigger our opportunity cost grows. Your end goal should be to employ as many money workers as possible to convert your active income into passive income, this is the process towards your financial independence. 

At Finsights, we want you, the everyday hero, to take control of your finances, become aware of financial independence, grow your knowledge, and let us be your financial independence partner. 

 Onward to Financial Independence