This is the fourth installment of a 5-part series examining the massive impact compound interest can have on your journey to financial freedom.
Previously in the series we introduced the phenomenon of compound interest, explored how it can serve as a rocket to riches capable of powering us through the millionaire barrier, and discovered how it can serve as the best double agent the world has ever seen.
By now you should be familiar with how to calculate the total amount of interest incurred over the life of a loan when you purchase something on credit, whether that be in the form of a credit card, auto loan, student loan, or a mortgage.
Adding interest costs to the original loan amount is a much more accurate method of determining the total cost of a purchase than is considering just the loan amount itself. Yet correctly calculating the TRUE cost of debt requires one final piece of the compound interest puzzle, which we haven’t yet addressed.
Today we’re taking a look at how compound interest creates a well-camouflaged, deadly cost of debt which has an outsized impact on your ability to escape the rat race and obtain financial freedom. This secret exists in the form of opportunity cost.
What Is Opportunity Cost?
Opportunity cost consists of the value one gives up in order to pursue an alternative course of action. Uhh… say what? Let’s try that again, in English this time.
Let’s say you’re an hourly employee who comes down with the flu, but you’ve already used up all of your vacation and sick days for the year. You can call in sick, but you won’t be paid if you do. Still, you feel absolutely terrible, so you make the decision to call in to your supervisor to let them know you’re ill and won’t be in for the day.
The opportunity cost of calling in sick in this scenario consists of two amounts:
- The wages you would have otherwise earned had you dragged yourself in to work.
- The future money you could have made with those wages had you invested them.
You gave up both the current value of those lost wages AND their future earning potential in order to pursue an alternative course of action (rest).
Loan Interest – The Predator You Can See
Now that we’ve defined the concept of opportunity cost, let’s explore how compound interest contributes to an additional, hidden cost of debt beyond simple loan interest.
Consider a scenario where you purchase a new, top-of-the-line TV for $1,200 using your credit card, which possesses the national average interest rate of 16.15%. You set a goal of paying off this balance in 12 months, which our familiar credit card payoff calculator tells us will require monthly payments of $108.96:
You diligently make these payments and pay off the TV a year later, paying $107.53 in interest on the balance along the way.
The average person would believe they purchased a TV for $1,200, but by now you know better. You factor in the effects of compound interest on the purchase and know that your TV cost a total of $1,307.53 ($1,200 + $107.53), 9% more than the original purchase price.
But don’t rest on your laurels just yet, because we still haven’t calculated the full cost of your new TV. What’s missing? You guessed it – we still have to factor in what else you could have done with the $107.53 which you paid in credit card interest.
The Stealthy Second Element of Opportunity Cost
After reading part 2 of this series, you’re now well aware of the power that compound interest has to grow exponentially over time in a savings or investment account.
So let’s assume that if you hadn’t been losing a portion of each credit card payment to compound interest, you would have taken that same amount and invested it instead at the same time that you made your credit card payment every month.
The opportunity cost of your TV purchase consists in part of the money you would have otherwise earned via compound interest had you saved or invested the cash that you were instead losing by way of compound interest on your credit card balance.
Foregone Future Value – A Seldom Seen Danger
Calculating this amount would be a quite monotonous and time-consuming exercise involving the use of multiple online calculator types were it not for the existence of this handy cost of debt calculator, which does all of the heavy lifting for us.
Plugging in our credit card balance, rate, and payment info from our TV purchase above (use monthly payments of $108.975 rather than $108.96 to resolve a rounding discrepancy) and using the historical annual average of 7% for our hypothetical stock market investments returns the below results:
We see per the Foregone Future Value column above that had you instead invested the $107.87 which you paid in credit card interest, it would have grown to a total of $112.86 after one year. So you’re out not only the original $107.87 lost to credit card interest, but the chance to keep that money AND earn an additional $4.99 in interest ($112.86 future value – $107.87 starting balance).
The total opportunity cost of the debt you incurred by purchasing the TV on credit is therefore the $107.87 you lost to credit card interest, plus the $112.86 you could have had in the form of an investment account balance – $220.73.
This is 18.4% more than the original purchase price of the TV, a hard-to-spot and stealthy surcharge.
Mortgage Opportunity Cost – The Silent Killer
An 18.4% cost increase is bad any way you slice it, but it pales in comparison to what happens when we calculate the opportunity cost of even larger loans over longer periods of time after giving compound interest a longer timeframe with which to work.
For example, let’s calculate the opportunity cost of paying 4% interest on a $100,000 mortgage in monthly payments spread over 30 years. Our mortgage loan amortization schedule calculator tells us that this will require monthly payments of $477.42 for 30 years and will result in a total of $71,869.51 in interest paid:
If that $71,869.51 of interest were not otherwise lining the pockets of our mortgage lender, we could have saved and invested it instead. The decision to forego this in favor of borrowing money to purchase this home represents the opportunity cost of this mortgage.
Plugging our loan information and a 7% rate of return on our hypothetical investments into our cost-of-debt calculator (enter monthly payment as $477.415299 to avoid rounding errors), we discover that if we had invested the money that we are otherwise losing to mortgage interest on a monthly basis, it would have grown to a total of $307,405.37 after 30 years:
This means that the cost of our mortgage in this scenario is far, far higher than the original $100,000 price tag considered by most. First, we have the $71,869.51 we’ve already signed away in the name of mortgage interest, a 71.9% increase over the original $100,000 loan.
Then we have the $307,405.37 we would have accumulated in our investment account thanks to contributions and compound interest growth over 30 years had we not signed that $71,869.51 away. This triples the original mortgage amount, a cost increase of 307.4%.
Adding the two together we find that the total opportunity cost of the mortgage is a mind-numbing $379,274.88, a 379.3% increase over the original $100,000 balance. This number represents the total cost of purchasing something which we could not afford outright and had to purchase on credit.
The Piercing Talons Of Debt Opportunity Cost
Projecting interest owed AND calculating the opportunity cost of that interest are essential to understanding the true cost of purchasing something on credit and falling into the clutches of debt.
In the above example, the couple considering the $100,000 mortgage may very well have made a different decision had they known the true price tag would amount to $479,274.88.
Informing your purchasing decisions with this information has the potential to dramatically change your long-term financial picture. Just one large-scale purchase avoided or modified can have an impact of hundreds of thousands of dollars.
Identify The Hidden Costs Of Your Own Debt
Using what you’ve learned in this article and the below compound interest calculators, see if you can pick out the hidden opportunity costs of your own debt:
- Compound Interest Calculator – Use to calculate the growth of a starting balance over time at a given interest rate (select “View Report” for year-by-year details).
- Debt Payment Principal & Interest Calculator – Use to calculate what portion of a debt payment is applied to principal vs. interest based on loan balance and interest rate.
- Credit Card Payoff Calculator – Use to view credit card payoff timeline, total interest incurred, and principal vs. interest portions of payments.
- Mortgage Loan Amortization Schedule Calculator – Use to calculate the total interest owed over a given mortgage term, as well as the impact of making additional payments (select “show amortization schedule” for year-by-year details).
- Cost of Debt Calculator – Use to calculate the opportunity cost of debt payments in the form of the interest you could have otherwise earned with the money you are losing to interest payments on debt (scroll down to see payment-by-payment details).
Extra Bonus – Did you know that owls have three different eyelids? Or that the world’s smallest owl is only 5-6 inches tall? Brush up on your owl trivia here and here to impress your family and friends with both your financial and feathered wisdom.