Understanding Opportunity Cost

Episode 331 – Opportunity cost is an often-overlooked factor that has an effect on every financial decision you make. Understanding this concept can have a significant impact on how you approach even the most basic of financial decisions.

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Transcript of Podcast Episode 331

Hello this is Bill Rainaldi, with another edition of Security Mutual’s SML Planning Minute. In today’s episode, understanding opportunity cost.

Opportunity cost can be defined as the value of what you give up when you forgo one choice in favor of another.[1] Here’s a simple example. If you spend an evening going to a baseball game instead of staying at home and watching a movie, you’ve given up the opportunity to spend that money—the cost of the ticket, transportation and parking—on something else. But you’ve also given up the enjoyment you would have gotten from staying home and watching a movie.[2]

Opportunity costs come into play with every financial decision you make. In other words, you finance every major purchase you make, even if you’re using cash. If you buy a new car and use your available cash, you will save some money. Since there’s no loan, there’s no cost to you in terms of any interest payments. But there is still opportunity cost. By paying cash, you’ve given up the opportunity to invest that money elsewhere and earn interest and/or dividends on it. This is something few people think about.

To put it another way, if you want something, you have to give up something else. Opportunity cost often gets ignored when making decisions. Higher education is a good example. If you think about it, the real cost of a college education is the tuition you pay, but not the room and board. You’re going to deal with the cost of room and board whether you go to college or not. But there’s more. The opportunity cost of going to college is that you gave up earnings that you would have had if you had chosen to work instead.[3] You sacrifice those current earnings in hopes of generating higher future earnings.

Home ownership is another place where opportunity cost plays a role. Over the long run, a house can be a good investment. But appreciation alone is often not enough to make it a good deal, even when the selling price is well above what you bought it for. To truly understand whether it worked out well, you also need to look at the taxes, repairs, capital improvements and closing costs. Not to mention the extra interest you would have earned had you chosen to live in a cheaper apartment.

Say you want to re-do your kitchen. It may not be cheap, but it might also add to the value of your home. In fact, it could end up adding more to the value than it costs. But that doesn’t mean it’s free. You’ve tied up some of your money on the kitchen, money which could have been used elsewhere, to (hopefully) be recovered when you eventually sell the house.

Also think about your mortgage debt. The concept of a debt-free retirement is appealing to most of us. But there are good debts and bad debts. If you have a low interest mortgage, opportunity cost may be a good reason to keep it rather than paying it off. You need to look at what you would do with the money if you didn’t pay down the mortgage. You might be better off if you invest it somewhere.

Then there’s the idea of doing it yourself. Fixing your front walkway yourself may be cheaper than hiring someone, and if you’re good at it, you may even like the results more. But understand that there’s another cost to doing this. By fixing it yourself, the cost to you is the value of whatever else you could have been doing during that time. Maybe you should consider your own earnings as an “hourly rate” as you measure the opportunity cost.

Finally, there’s also a practical, everyday application to understanding opportunity cost. It can be a good way to make the most of your cash flow. Every financial decision you make—some big, some small—can either help you or hurt you in the future. You need to look carefully at the long-term impact. Even small expenditures, repeated over time, can have a big impact.

Here’s an example. Let’s say you go out for lunch a couple of times a week. Could that money be better used elsewhere? That is money that you could otherwise be investing and growing. And as we discussed many times, compounding can make even small amounts become large over time, especially when it involves a steady flow of cash, such as the $50 or so you may spend every week going to lunch.

It’s easy to ignore opportunity cost. But if you don’t think it through, you could end up throwing money into things that keep you behind in your savings, instead of things that get you closer to your financial goals.

[1] Munsey, Bobbie Anne. “8 Opportunity Cost Examples (Plus Definition and Uses).”  Indeed.com. https://www.indeed.com/career-advice/career-development/opportunity-cost-examples (accessed March 31, 2025).

[2] ECONLIB Guides. “Opportunity Cost.” Econlib.com. https://www.econlib.org/library/Topics/College/opportunitycost.html (accessed March 31, 2025).

[3] Roberts, Russell. “Getting the Most Out of Life: The Concept of Opportunity Cost.” Econlib.com. https://www.econlib.org/library/Columns/y2007/Robertsopportunitycost.html (accessed March 31, 2025).

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