For our discussion we are going to define the word “finance” as simply a cost.
It’s obvious that when we borrow money for a purchase we have an additional cost, the cost of money or interest. When we borrow someone else’s money we must pay them interest for the use of that money, this is a real and easily identifiable cost.
However, did you know that when you pay cash for a purchase that there is a cost associated with that as well? It’s just as real as paying someone else interest for the use of their money. When we pay cash we incur what is called “OPPORTUNITY COST.”
Rarely is opportunity cost calculated when we make a purchase, it’s a very easy calculation to make and should be considered before you make a cash purchase. All you need is a Time Value of Money (TVM) calculator and if you don’t have one there are several websites that will let you use one for free. I found one here: http://www.zenwealth.com/BusinessFinanceOnline/TVM/TVMCalculator.html
Opportunity cost is what I’m ultimately giving up in growth for this cash purchase. In other words what would my money be worth in X number of years if I were able to keep my cash working for me. If my money is used to purchase an item, I have elected to give up the “opportunity” for that money to make money for me…..forever….hence the term OPPORTUNITY COST!
The calculation is very simple all you need to do is plug in these variables. How much is the purchase, how many years are you going to run the calculation. I typically use a retirement age such as 65 for the calculation. Next I need to plug in an interest rate that I can get safely on my money. I would use somewhere between 4 and 6 percent in today’s environment.
So what is the purpose of this calculation and why do I need to run it? What I want to know is the TRUE cost of my cash purchase. I know the true cost if I finance because it’s on the contract as TOTAL PAYMENTS both principal and interest added together. But what would my money have grown to if I kept it working for me?
Let’s suppose I’ve saved for years to pay cash for a $25,000 car. Lets also suppose I could get 5% safely on my money over time. I have 25 years before I retire, so I’ll use that as my time horizon. What is the result? I would have an additional $84,658 in my account had I kept my cash working for me. At 8% that would equate to $171,211. Could that make a difference in your retirement? So to pay cash in this example cost me in opportunity the ability to have $84,658 dollars in my account. I traded $25,000 today for a car instead of keeping the money working for me and having $84,000 later.
The reason for this exercise is to show you that even paying cash has it’s “finance cost.” No matter what we do, pay cash or finance, there is a cost. So is there another way? We’ll teach you about creating your own family banking system later so that you will not only recapture the cost of the item purchased, but pay yourself the interest you would normally pay to use someone else’s money. This is the only way to avoid finance cost and opportunity cost.
Think about all the items you’ve paid cash for over the years. Add them up run a TVM calculation and you’ll see that the path to wealth for most is the roadblock they put up for themselves in the way they make their purchases. Wealth is not determined by IF you make purchases, we all make purchases, but in HOW you make those purchases.
I’ll show you how to create wealth by controlling the “banking” equation in your finances.