Do you ever find yourself asking if you’ve made the right decision on how to spend your money? Or worry that you’re choosing your more immediate problems (like an outdated wardrobe or rumbling belly) over those nagging long-term issues (like credit card debt and student loans)? Don’t worry, you’re not alone. Prioritizing your spending can be hard, but done right, prioritization can literally pay off.
To figure out what purchasing decisions are most important, most people employ a piece of economic theory, even if they don’t know they are. It’s called “opportunity cost”, and the basic premise of it is to ask yourself, “What would happen if I did x with my money instead of y?” For those of us who are fortunate enough to cover basic expenses and then some, considering the opportunity cost for things that you want to buy but don’t truly need can help save you more than you might think. Let’s look at a couple of examples.
New clothes vs student debt
Thomas has many thousands of dollars of student loans to pay off. He’s been putting all extra loan payments toward his highest-interest loan in order to pay off his student debt fastest and with the most savings, also known as the avalanche method. His highest-interest loan had an original balance of $2,000 at a 6.8% interest rate. Thomas is considering buying new clothes, which would cost him around $300. How much would Thomas save if he didn’t buy the clothes, and instead put that $300 toward his highest-interest loan?
The Opportunity Cost
If Thomas put an extra $300 just this month toward his highest-interest loan, he would end up paying $2,575 total for the entire life of the loan, assuming all future payments were minimum payments. If he put the $300 toward the clothing purchase instead, he would end up paying about $2,755 total for the entire life of the loan, also assuming all future payments were the minimum. That means his opportunity cost in this situation is $2,755-$2,575, or $180. In other words, Thomas would save $180 by putting that one-time extra payment of $300 toward his highest-interest loan instead of toward new clothes. He would also pay off the loan 20 months faster—almost two years—with the one-time, $300 extra payment.
It’s important to note that while the new clothes would add some value toward Thomas’ life initially, the clothes would soon lose their spark and no longer feel “new” to him, thus losing some of their previously-perceived value. It’s difficult to calculate the dollar value the new clothes would have on Thomas’ life, but we do know that their value to him would decrease over time.
Car upgrade vs retirement savings
Lucy is leasing a nice car, but is considering upgrading to a newer car, which would mean a $100 increase in monthly car payments. If Lucy continued leasing her current car and put that extra $100 toward retirement each month, how much money would she save?
The Opportunity Cost
First, let’s assume that money put into Lucy’s retirement savings would compound at an average of 7% based on historical stock market trends, and assume that her current retirement savings total about $29,567 (based on a $50,000 income for 10 years, and a monthly 4% of her income going toward her retirement). With these assumptions, we can estimate that she’d make about $5,494 in a year with her monthly extra $100 going toward retirement. If Lucy decided to upgrade her car and not pay any extra toward her retirement, then she’d have about $4,210 in a year in retirement savings. The opportunity cost in this situation over a year would be $5,494-$4,210, or $1,284. That means Lucy would make about $1,284 over a year if she decided to put that extra cash toward retirement rather than a newer car.
Even if Lucy put off upgrading to a new car for just a year, that extra $1,200 she put in her 401(k) for that year will continue to grow exponentially into the future.
Meals out vs credit card debt
Lindsay likes to eat out at restaurants, which isn’t helping her pay off her outstanding credit card debt. If Lindsay makes more meals at home and dines out less, she’ll have more money to pay off her credit card. If she spends $50 less each month by eating out less and putting that toward her 15% interest, $300 credit card bill, how much money would she save?
The Opportunity Cost
Because credit card debt typically compounds, we can expect to see big payoffs from Lindsay increasing her payments toward her credit card debt. If Lindsay dined in more often, saving $50 a month that she put toward her credit card debt on top of the minimum payment, assuming she did not add more debt to her credit card, she would be credit-card-debt free in five months, and would have paid $311 total. If Lindsay continued dining out and paying only the minimum on her credit card debt while not adding more debt to it, she would have paid $347 in 24 months.
The great thing about Lindsay’s scenario is that eating out less each month would soon become the norm for her. Since she’d be dining out less, it would also likely increase her enjoyment when she did dine out, since it would be a rarer occasion to dine out than it used to be.
As you can see from the examples above, prioritzing has its benefits. You can use this student loan calculator, compound interest calculator, and credit card calculator to estimate how much you could be saving by prioritzing how you spend your money.
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