Photo by Sophie Smith
That’s a very interesting question. In my Post #32, I outline the cost of buying a 2019 BMW 3-series vehicle. Instead of using the conventional approach of calculating the cost of the vehicle using just the initial cost of the vehicle plus the cost to finance it, I added in the Opportunity Cost of purchasing the vehicle as well.
What IS Opportunity Cost?
So what exactly is Opportunity Cost? Simply stated, it’s what you forgo by not having done something.
In this case, by NOT being able to invest the money being used to purchase the identified vehicle in question we also deny ourselves of any financial return on those monies.
Even though the actual out of pocket “real dollars” that are being lost to purchase this vehicle are the only dollars that were actually materially in your possession at one point in time, the money that could otherwise have been generated by these same dollars, which are now NOT being generated, is the Opportunity Cost of buying that vehicle.
The $380,730 3-series BMW
What is so interesting when looking at the Opportunity Cost as part of any purchase, such as this example of the BMW, is that it turns an initial purchase of a $40,250 vehicle into the loss of $380,730 over 30 years. Much of this is attributed to the incredible impact of the compound interest effect and the time spent in the market.
Taking this concept into consideration, it sheds an incredibly different light on the ability to rationalize a “low monthly payment” for any of our purchases when considering the much larger overall cost when adding the Opportunity Cost.
What is also interesting when including Opportunity Cost as part of any purchase, is that it also emphasizes the importance of the principle that you should never purchase a Non-Income Generating Asset.
This not only becomes obvious when you take into account the Opportunity Cost of any item but for an Income Generating asset, even if it isn’t an asset that generates positive cash flow, it significantly reduces the Opportunity Cost of owning that asset.
A great example of this would be the Opportunity Cost of housing. For someone who purchases a single-family house, arguably a Non-Income Generating Asset, the Opportunity Cost of that house is only offset by any appreciation upon its sale.
Now in comparison, a multi-unit building generating income significantly reduces the overall cost of owning the asset when considering the Opportunity Cost, assuming that the income at least can offset the mortgage or generates positive cash flow that can be invested to generate additional income.
The REAL cost of a single-family house
So what would this look like using real numbers? Let’s assume we purchase a single-family home for $150,000. Using some standard calculations, we’d have to put at least 10% of the purchase down, or at least $15,000. That would leave us financing $135,000 at 3.92% interest for 30 years. At this calculation, we would be paying $638 in monthly payments and over 30 years would be paying a total of $229,680 dollars for the house with $94,680 paid in interest.
For the sake of this exercise, let’ assume that we aren’t able to either live in our parents basement with no rent or at no cost “living in a van, down by the river” and that our monthly rent for an apartment also costs exactly $638 a month.
That would basically leave us where purchasing a house didn’t cost us anymore than it would have cost us for renting an apartment, so nothing really gained or lost on either side of the equation.
However, let’s further assume that our house appreciates in value by an additional $25,000 at the end of our 30-year mortgage, for a total market value of $175,000. Let’s also assume that we sell the house at that point pocketing our original $150,000 and having increased that amount by $25,000.
What’s the real Opportunity Cost of owning a house?
Now what was the Opportunity Cost of owning that house? As mentioned, it is a bit of a difficult comparison due to the fact that we had to pay to live somewhere so it wasn’t like we had a ton of options to not have spent any money on this expense.
That said, what would it have looked like had we been able to have put the money that we spent on housing into an investment that generated money for us, an ‘income generating’ asset?
Well, if we would have been able to put that initial down payment of $15,000 in an S&P 500 Index Fund yielding 7% annually, along with the monthly payment of $638 dollars, over 30 years we would have had a total of $837,375 dollars in our pocket instead of having paid out $229,680.
Due to the fact that we paid $229,680 dollars AND we lost the opportunity to have had $837,375 dollars at the end of the mortgage period, the purchase of that house denied us from making $607,695 dollars. Thus our Opportunity Cost of buying that house was $607,695 dollars minus the $25,000 in appreciation or $582,695 dollars.
The ultimate house hack…Income Generating Assets
Is there a way to eliminate or significantly reduce the Opportunity Cost of housing? Absolutely yes! This is where we turn housing into an Income Generating Asset. Let’s assume we purchase a duplex for the same $150,000 dollars and we have a tenant in the second unit that happens to pay us $638 a month which completely offsets the cost of our mortgage payment. In this example, what is the Opportunity Cost of owning this duplex?
For starters, we know that our initial $15,000 down payment not being in the market for 30 years comes at an Opportunity Cost to us. In fact, we would not have $114,183 (7% interest for 30 years) and therefore lost the ability to make $99,183 on that initial down payment.
However, that’s where it stops. Assuming that we didn’t pay another dime for that property (obviously excluding other monthly costs like taxes, water and sewer bills, etc.) we would be using someone else’s money to pay for our monthly housing costs over that 30-year time frame. In another words, we wouldn’t have lost the ability to have not earned money on the money that we were paying for housing because beyond our initial investment, we weren’t paying anything for it.
To sweeten the pot, let’s also assume as we did in the first example that we sell the property when our mortgage expires and realize that $25,000 in appreciation on the value of the property (assuming that other comparable properties in the market that generate $638 a unit for a duplex sell for $175,000 dollars). Factoring in this $25,000 positive offset we would receive at the end of the 30-year mortgage duration, the Opportunity Cost of this duplex would be $99,183 – $25,000, or $74,183 dollars.
Conclusion
As a recap, buying the single-family house would have an Opportunity Cost of $582,695 dollars versus just $74,183 dollars for the duplex. That’s a WHOPPING difference of $508,512 dollars to have owned a single-family property instead of an income generating property.
So for those of you that believe you know the “cost of everything”…do you REALLY know the ‘true’ cost of everything? Going forward, before making a purchase that has the potential to significantly diminish your wealth, add the Opportunity Cost in to see if it’s really the bargain you thought it was!
