The following is a guest post from the crew over at Kasasa, a financial technology and marketing services company for the banking industry. Kasasa provides local banks and credit unions with marketing, resources, and innovative products including free checking. If you haven’t checked out their services, I highly recommend you do so and find an institution near you that offers Kasasa’s free checking.
It’s hard to avoid debt.
Without it, the idea of buying a home or going to college would be unattainable for many. Even the people who we see as successful or enviable most likely have debts in some form.
So how can you utilize debt to grow your worth without digging a hole you can’t get out of? Simple: minimize the opportunity costs of the debts you hold.
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What is opportunity cost?
In laymen’s terms: opportunity cost comes down to weighing your options and calculating the most efficient path to achieve your desired outcome.
It’s represented by this equation:
Opportunity Cost = Return of Most Lucrative Option – Return of Chosen Option
Why is opportunity cost important?
Since debt has become such a norm for many Americans, we’ve lost the urgency to get out of debt. The mindset can easily become: “Well, these minimum payments are so small, they don’t really impact my lifestyle. Why should I rush? Being in debt isn’t so bad, right?”
This mentality will cost you in the long run. Let’s look at a practical example that will reveal just how much you ultimately pay for your debt. And how much you could be saving if you calculated the opportunity costs of your debt now.
Let’s say you have $30,000 in student loans you need to pay off over the course of 40 years at a 5% interest rate. That’s a pretty long time to pay off your loans, and if you have a good job, the estimated $144.66 you need to pay each month might not hurt your lifestyle so much.
However, by the time you pay off that loan, you will have paid a total of $69,436. That’s almost $40,000 in interest over the life of the loan.
We don’t need to tell you what you could have done with that money.
Now, taking into account the opportunity cost, what if you paid $50 extra on the principal each month?
First of all, you would pay the loan off in about 20 years, cutting the life of the loan in half. More importantly, by paying an extra $50 a month, you will have paid only $18,109 in interest. That’s almost half of the total cost if you’d only been making the minimum payments.
This example applies to all types loans –– your mortgage, a personal loan, your car note, etc.
Calculate the opportunity cost of your debts early on. This will help you find the optimal balance between life and debt. As with any type of debt, paying more than your monthly minimums will highly benefit you in the long run.
Can’t think of how to scrounge up an extra $50 a month? Take the money you save using these tactics and throw it towards your debt.
When it’s all said and done, those thousands of dollars you saved by calculating your opportunity cost can be used however you like. Maybe it’ll be time to fund that dream trip to Europe, or put a down payment on a new home.
One final thought
Opportunity cost isn’t confined to debt. You can look at the opportunity cost of many things –– like the interest you’re earning on your checking or savings account, or whether you should stay at your current job vs. go freelance.
Keep this handy definition in your back pocket, and pull it out whenever you’re weighing your financial or career options. Your future self will thank you for thinking ahead.