Lost opportunity: The cost of paying cash, Pt. 1Article added by Jeffrey Reeves on January 6, 2009
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There are hundreds of money myths that allow people to feel good about bad decisions. Popular pundits on TV and radio whose main credential is that they are smooth talkers or enthusiastic preachers of their unique money gospel propagate most of these myths.
One of the most deceptive and destructive of these money myths is that "paying with cash" is always better than any other alternative. This erroneous belief ignores a basic economic principle: lost opportunity cost.
This white paper deals with lost opportunity cost, an elusive and challenging concept that does not lend itself to easy verbal explanation. The author does not hold this brief treatise out as a definitive study of the subject, but rather the intention of this article is to shed some light on a complex topic and spark a discussion that will lead to a deeper understanding of the subject.
A basic grasp of the concept of lost opportunity cost is, however, fundamental to understanding, building and maintaining a successful personal economy.
Part I: What is lost opportunity cost?
According to the Merriam-Webster Dictionary...
"Lost opportunity cost is the value of what is lost when you choose between mutually exclusive alternatives."
Furthermore, the NationMaster Online Encyclopedia describes it this way...
"Opportunity cost is a central concept of microeconomics. The opportunity cost of any given choice is the most valuable, i.e., the second best, alternative."
You can estimate the values of both the discarded alternative and the choice you make before you decide between two or more competing options. The actual cost of a lost opportunity can only be accurately determined, however, after you have chosen one option, rejected all others, and experienced the outcome.
For example, you might be considering the purchase of a new lawnmower; either a gas-powered mower or an electric-powered mower. We'll postulate that, even after considering the cost of fuel and maintenance over its expected useful life, the gasoline engine mower appears to be less expensive. The opportunity cost with gasoline at over four dollars a gallon may be entirely different if that decision came when the price of gas was less than two dollars a gallon.
Lost opportunity cost can apply to everything from choosing a mate to choosing a desert after dinner. You can measure it using money, a scale or any other yardstick that is appropriate. Since this white paper deals with lost opportunity cost only as it relates to the use of money, especially cash money in your personal economy, the measure it uses is dollars.
R. Nelson Nash, author of Becoming Your Own Banker, provides insight into lost opportunity cost as it relates to always using cash, and highlights one benefit that you might gain from understanding lost opportunity cost in your personal economy:
"Any time that you can cut out the payment of interest to others and direct that same market rate of interest to an entity that you own and control...you have improved your situation." (Third edition, pg. 40)
A more thorough way of saying the same thing comes from an experienced advisor who learned from Mr. Nash. He says: "You always finance what you buy."
Part II: Money is capital too!
- If you borrow the money to buy something, you repay principal and pay interest to another.
- If you pay cash to buy something, you give up both the principal and the earnings your cash would have brought you.
Understanding the fact that money is "capital" is the key to understanding lost opportunity cost as it relates to cash expenditures. For example, it's easy to see that a person who owns a 160-acre parcel of arable land has capital. The owner might consider these optional uses of that capital; plant one or more cash crops each year or sell off the land as lots. Each choice would produce different results, both in terms of money and in terms of time.
Either way, the capital remains -- either land or cash.
- Cash crops promise an uncertain but probable income each year and preserve the basic value of the capital asset.
- Subdividing the land and selling off the lots would eventually convert the land into cash.
Money in the form of cash is, therefore, capital as well. In banking, cash contributes to the tier one capital that determines the stability rating a bank receives from regulators. Corporate balance sheets include cash holdings among their capital assets. Your personal economy runs almost exclusively on its capital holding of cash.
Why, therefore, is there the modern-day myth that paying cash for everything is always the best choice? Why the insistence that you deplete one of your most valuable and liquid assets on a regular basis, which, it's important to note, increases the cash account of the entity that receives your money? Isn't the reason supporting the myth the very fact that the myth serves the interests of those who propagate it, rather than your interests?
Are you ready to debunk this myth? Ask yourself:
Be sure to read Part II of this article for more exciting details on the cost of paying cash.
- What do you lose when you pay cash?
- Should you consider just the cash in your decision?
- Is there a benefit you might receive from using your cash differently?
- Where are you getting the cash to support a decision?
- Is what you give up when you use cash worth more than what you gain by doing so?
- Are there alternatives to cash that you should consider?
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