Saturday, November 1, 2014

Where Opportunity Cost Makes Sense - in Spending

A reader writes:
I think you missed a major point on your post on opportunity cost but then you came back to almost address it on your next post.

I think opportunity cost is very relevant to the average person, not just businesses.

If I have $400,000 and want to buy a house, maybe I spend the whole amount of money on a $400k house move in and live happily.  If I could have bought a house for $200k that equally met all my needs as well, I would have $200k left to do something else with such as put into bonds, stocks, CDs, or even a small business.  That is absolutely an opportunity cost for the average person.  If I put the money into a 3% investment that is $6,000 a year into my pocket.

That is of course different than the marginal costs that my more expensive house would come with, higher property taxes, probably heat and cooling bills to match and possibly higher upkeep costs.  Add those two together and you have the total difference in what that more expensive house is really costing you.

I know a lot of people don't pay cash for a house but I think it still applies.  They will presumably eventually own the house after paying the mortgage for many years and it still winds up that you have 200k more tied up in the house that could have been used for something else.

Thanks for your e-mail.  I think we are saying the same thing, although sometimes I do not articulate it as well.

What you are saying is that is the model I used in my own life.  I had a $200,000 house, and when I graduated from law school, many of my friends "moved up" to larger and more expensive homes in the $400,000 range.  After all, this is the level of living they "deserved" - right?

In fact, I came close to making the same mistake.   We once visited an open house of mini-mansions they were building near us, and for $400,000, we too could have had granite counter-tops and stainless-steel appliances.   But we decided we didn't really need to spend another $200,000 on a house, when the one we lived in was more than adequate.

I used that  $200,000 and bought a duplex, which I rented out (which generated income).   That is the "opportunity" that people are missing out (that, or similar investments) when they buy look-at-me houses or fancy cars or other consumer goods.   They miss out on saving and investing by spending.

Then it comes to the decision of SPENDING or NOT SPENDING, then opportunity cost makes sense.

When it comes to the decision of SPENDING CASH or BORROWING MONEY, it makes less sense - if no sense at all.

The comparison the lenders make (and it is lenders making that argument) is that "if you get a mortgage (or car loan or whatever) then you can use that cash to invest and make money!  So it is better to borrow money!"

But of course, that is comparing a speculative stock investment with a guaranteed rate of return.

The best thing to do is buy as much house as you NEED, not WANT and invest the rest.   But if you can pay off your mortgage over time, that is better than being constantly in debt on the premise that it allows one to "invest".

And no, a house you LIVE IN is not an investment, as it merely appreciates enough in value to offset the costs of owning it, over time, as I addressed in another posting.   A house you RENT OUT, however, makes money for you, just as an investment in stocks and bonds.   Sadly, the Real Estate industry has sold an entire generation on the idea that you should "buy as much home as you can afford!" as you will "make more money" by buying a larger house.   This is not often the case, however.

I live on a retirement island, and I am seeing a lot of 65-year-olds with mortgages.   And some of them are in serious financial stress as a result.

Our parent's generation would pay off their mortgage over time, and when they retired, downsize to a house that was paid for in cash.   No one could take that away from them, and their cash-flow requirements were low (which meant they spent less money, which put them in a lower tax bracket).

I think today, the idea of perpetual debt is not only being taught- many folks believe it wholesale.   Most folks think debt is a natural condition that follows them from birth to death.

Actually, there is a great Science Fiction story to that effect, which describes a future world where people go so heavily into debt that they pledge their children's future income to debt agencies, so they can have all the gadgets they want today.   It was written back in the 1950's, but it seems even more relevant today.

We are, it seems, the debt generation!