You could miss the chance to build wealth more effortlessly by ignoring opportunity costs. While many economists know about the time value of money, very few understand how it can apply to real-world cash. It seems intangible, yet failing to consider it can have a massive impact on your wealth journey. So, today we’re answering the questions on your mind. What is opportunity cost? Why should you care?
The Definition of Opportunity Cost
Essentially, opportunity cost is the money you “lose” by taking one opportunity over another. For example, if you spend $1,000 instead of investing it, you have an opportunity cost of whatever that money could have earned in an alternative investment (over the entire duration of the investment). As you can imagine, those costs can turn quite extreme, quite quickly. And while these costs seem intangible, they’re very real. After all, if you DID save or invest instead of spend, you really could have those earnings.
The thing about money is that it has a “time value,” which means that over time opportunity cost grows. That’s how interest works. So if you put that $1,000 in an account earning 5%, over a year that might not seem like a lot of interest. But over 30 years, that money could compound into over $4,000. When you use a vehicle like whole life insurance to save, you can truly get uninterrupted compounding growth for 30 years (and even far beyond that).
When you spend that $1,000 today, you can never recoup that opportunity cost. It’s lost the ability to ever earn a rate of return for a year, let alone 30 or more. And you may earn a NEW $1,000, yet you’ve lost that initial momentum.
The Opportunity Cost of Your Financial Decisions
Below are just a few examples of ways people often forget to measure their opportunity costs.
1. Lifestyle Spending
Lifestyle spending is the biggie: people make purchasing decisions every day that influences lifestyle spending. The mortgage you choose, the car you drive, the clothes you wear, and so much more affect your monthly expenses. Yet these expenses can prevent you from accumulating wealth, especially when you’re starting out.
Warren Buffett is a great example is a billionaire who lives below his means. He could have anything he wants, yet he chooses to live frugally. Living in the same home (in a middle-class neighborhood) for decades, and even choosing to have a simple civil ceremony for his marriage, Buffett understands the power of his money. He knows that each dollar is a potential seed for more wealth, so he’s not frivolous.
It’s not just the size or cost of your home that is an opportunity cost, it’s also the mortgage you choose. Many people think that the 15-year mortgage is better because they “save money” on interest. However, a calculation over the same 30-year time frame proves that the cost of a 15-year mortgage is the same as a 30-year. In fact, the losses could be even greater, because those with a 15-year mortgage usually aren’t saving any money for those 15 years.
Taking a 30-year mortgage and saving the difference into a whole life insurance policy can actually help you build an emergency/opportunity fund right away, while recouping some of the opportunity cost from the higher payment. The interest cost is just a “fun fact” compared to the opportunity cost of not saving for 15 years.
3. Insurance Premiums
Insurance is a necessity, yet many people are paying more for their insurance than they ought to. Most often, this happens when people choose to have a low deductible, which increases their monthly rate. The perception is that in an emergency they’ll be better able to afford it. However, if you simply raised your deductibles and saved the difference, you’d have an adequate emergency/opportunity fund to help. The thing about property insurance is that it’s a big IF, not a WHEN like life insurance.
Term insurance is another opportunity cost, because that’s insurance that will most likely never see usage. Additionally, there’s no cash value or other savings component to balance the premium costs. That’s not to say term insurance is bad. However, it’s not the most efficient option, and should really be used as a supplement to whole life insurance. When you have whole life insurance, every premium you pay builds equity in your policy (cash value). This means your money is doing multiple jobs, and can even do a few more via a policy loan!
4. College Funds and Qualified Plans
Parents often begin saving for education when their children are young, yet they use accounts that lock the money up for a single purpose. Not to mention, those plans are tied to the stock market, which means they can be volatile.
The same goes for funds that are earmarked for retirement. Many people choose a 401k or IRA to save into, yet the options to use those accounts are so limited. Instead, you can recoup the opportunity cost by saving into a whole life insurance policy that can be leveraged for anything, including college (and also retirement, vacations, investments, etc).
Why Does Opportunity Cost Matter?
You may still be thinking that opportunity cost is this intangible thing, yet the decisions you make today can have a major impact on your future self. You may not be able to see it now, yet in the future you might just look back and wish you had made some different choices.
There’s an opportunity cost to every decision, so don’t think it’s bad to have opportunity costs. You just have to learn how to factor it into your decisions so you can benefit now and later from your choices. Your future self will thank you.
If you’d like to speak to a Prosperity Economics Advisor about whole life insurance and recouping your opportunity costs, contact us today to be put in touch with someone.