Lost opportunity: The cost of paying cash, Pt. 2Article added by Jeffrey Reeves on January 12, 2009
Jeffrey Reeves MA

Jeffrey Reeves

Denver, CO

Joined: March 24, 2010

My Company

EUREKONOMICS[tm]

In part one of this article, we discussed the meaning of lost opportunity cost as well as why understanding the fact that money is "capital" is crucial to understanding lost opportunity cost as it relates to cash expenditures. Let's move on to some other ways to debunk the that that paying cash for everything is always the best choice

Part III: The role of debt-to-others vs. Debt-to-self

The always-pay-cash mantra usually chants an "all debt is bad debt" chorus. The purveyors of this myth seldom, if ever, consider a third, fourth, or any other alternatives. I'm not suggesting that debt is good. It makes sense in terms of lost opportunity to pay cash in lieu of putting your purchases on a credit card that it may take years to repay. It may also make sense for some individuals to pay off a mortgage early to save tens of thousands of dollars in interest.

However, debt may also provide leverage in certain situations. More importantly, if you have studied the Money for Life Model that lets you be the bank, you realize that debt to yourself creates wealth more readily than other, more risky systems and paradigms.

Consider these three ways to use cash to pay for a $24,000.00 car:
    1. Take cash from a $24,000.00 savings instrument. After a $2,000.00 discount off the purchase price from the dealer, you still have $2,000.00 to put into a CD at 4.15 percent, which yields $2,450.90 during the 60-month finance period.

    2. Borrow $22,000.00 from your credit union at 6.5 percent (you still get the dealer discount for cash) and withdraw the $430.46 per month payment for 60 months from your $24,000.00 savings instrument. You end up repaying $25,827.37 including interest and have just over $2,400 left in savings.

    3. Take the $400.00 per month interest-free payments of to the dealer's finance arm for 60 months from your savings plan. This would reduce the $24,000.00 to about $2,000.00.
Does it surprise you that leaving your CD intact, borrowing from the credit union, or taking the zero-interest option all produce about the same result? It shouldn't. In each of these cases, you effectively pay cash. When it's all over, you have depleted your savings, have very little money and a five-year-old car that is worth virtually nothing. As our senior advisor suggested earlier, "If you pay cash to buy something, you give up both the principal and the earnings your cash would have brought you."

Imagine the difference if you had borrowed the money from your own wealth creation and money management account and repaid yourself? At the end of the 60-month payoff period, you'd have both the principal and interest returned to your account... and you'd still own the five-year-old car.

Part IV: The fallacies

Here's the first fallacy in the myth. The myth assumes that the payments you don't make [on the automobile, for example] are going to be used either to replenish your savings or to pay off other debt. In this example [using numbers from BankRate.com in order to be honest and fair in our presentation], we took the cost of the purchase from the same source in each case and did not replenish the savings.

If we factor in a monthly payment of $430.46 being made to replenish the savings plan -- or, in the case of the credit union loan, leaving the money in the savings vehicle and making the loan payments to the credit union -- and calculate the results for each approach, the results in each case are, again, similar. You would replace the money you spent on the car plus a little interest. The auto dealer is still the one that made a profit from the transaction while you lost the earning power of your money during the repayment period.

This uncovers the second fallacy in the always-pay-cash myth. The myth assumes that there is only one instance of the transaction type that is discussed or illustrated: one car, one refrigerator, one vacation, one of anything. The reality is that you will have to buy many cars, refrigerators and vacations.

The always-pay-cash myth doesn't address this issue. This myth, like most other shallow financial paradigms, relies on a snapshot in time. The snapshot captures a scene that ceases to exist the instant it is taken, and is immediately at odds with your current reality.

This leads to the third and most compelling fallacy of the always-pay-cash myth. Since the myth relies on creating support for its proposition, it consistently represents unrealistic results for both its positive effects and the negative results of not following its rigid mandates. It compares apples and elephants as if they were of the same species. It discounts any alternative that does not support its position -- or improve the ratings of the pompous pundit that promotes it on radio or TV.

When investments are recommended -- and they usually are -- an unrealistic rate of return is illustrated. You may be reminded that the "market" has delivered a hypothetical 12 percent year-on-year return. However, it's not likely the proponents of the suggestions will tell you that individual investors -- people just like you and me -- during that same period have averaged only 2.9 percent gross returns and less than 1 percent returns adjusted for inflation and taxes.

If the pundit or advisor suggests a savings plan, they will recommend that you maintain six months or so of reserves. They will give little or no consideration to the surprisingly unsurprising surprises that life delivers on a daily basis; the emergencies that create the great sucking sound that decimates your reserves when the roof leaks and has to be replaced, or the opportunities you have to opt out of because you have no ready cash.

One final thought and a conclusion...

So what's a person to do?

First, recognize that the concept of lost opportunity cost is, at best, misunderstood by the celebrities and pundits who promote their personal form of mucked-up economics on radio and TV shows. (I am uncertain how I would fare if ever I had my own radio or TV show. I'd hope to emulate Ben Stein, who is fearlessly well-informed and honest.)

Second, recognize that the vehicles you choose to consider when making a lost opportunity cost decision will determine the validity and outcome of your decision. If you rely on hyped-up hypothetical illustrations of investments with 6-percent or higher assumptions, your choices will eventually destroy your financial foundation and your house will fall. If, on the other hand, you choose a more conservative and realistic approach based on guarantees and high probability returns like those available in participating whole life insurance policies, your financial foundation will rest on rock-solid ground and your framework will strengthen.

Recall the lawnmower example from early in this discussion. You can estimate lost opportunity cost before the facts, but you won't know the actual results until later. Here's some additional advice from the annals of folk wisdom that you might also want to consider:

As country-western artist Kenny Rogers sings, "You gotta know when to hold 'em, know when to fold 'em, know when to walk away, know when to run."

And don't forget what Will Rogers cautioned; "I'm more concerned about the return of my money than I am about the return on my money."

Lost opportunity cost is one of the most powerful tools you have to evaluate financial opportunities. The Money for Life Model seamlessly incorporates this tool into every aspect of its approach to helping you build a successful personal economy that lasts "in good times and bad" and, in fact, works better in bad times.

References

I've stayed away from social commentary [there's a ton of it out there] and tried to avoid the really esoteric [although a couple of references are included to demonstrate how challenging this discussion can become]...

www.csun.edu/bus302/Lab/ReviewMaterial/micro1.pdf -- thoughtful and comprehensive discussion for business applications

www.investorwords.com/3470/opportunity_cost.html -- definition and links to key words in the definition

www.mymoneyflow.com/loc.htm -- short and to the point

www.moneyinstructor.com/lesson/opportunitycost.asp -- long and detailed

www.netmba.com/econ/micro/cost/opportunity/ -- clear and concise

www.moneyinstructor.com/art/costcapital.asp -- convoluted math deals with the cost of capital and might be worth the pain

cepa.newschool.edu/het/essays/margrev/oppcost.htm -- don't even open this one unless you have a couple of hours and a good psychiatrist -- unless, of course, you are actually an economist who understands "Wieser's Law."

imet.csus.edu/imet1/mica/econ/introchpt1p2.htm -- OK. If you really want to damage your brain, try this one.

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