Defined as the next best alternative forgone, it is a popular concept used to assist entities in making decisions given constraints on resources.
Put differently, given the limited supply of critical resources, what are you giving up on being able to expand those resources on one activity?
Although this is often used by companies, it is a very good concept to assist in making personal decisions too.
The most common way that I get to engage with this concept is around investments as well as borrowing. Often people ask what the best way to save or invest is because they are trying to make the most out of their money.
Of particular importance is knowing whether it is better to save some money when paying off a loan or simply focus on attacking your debt to pay it off. The answer to that is always “it depends” and the defining factor is the opportunity cost of your choice.
When assessing opportunity cost, it is important to note that you should not only focus on the money you could earn if you were to invest in something but also rather what you can avoid paying if you were to choose an alternative course of action.
For example, you have N$30 000 up for investments. You could do one of the followings:
- Invest it in a fixed-term deposit, earning an interest of 5.7%. If early withdraws are done, you incur a 1.5% penalty on the value of the funds.
- Pay off a one-year personal loan with an interest rate of 10%.
- Keep it in a call account for emergency purposes with an interest rate of 2.4% with on-demand access to the money.
What is the cost associated with each of the above options on an annual basis:
- If you do not invest in the fixed-term deposit, you will lose out on the interest of N$ 1 710.
- If you do not pay off the loan, you incur an additional N$ 1 649 in interest (compounded).
- If you invest in the call account, you will lose N$720 interest and either incur an early withdrawal penalty on the funds in a fixed-term deposit or interest on a personal loan if you do not have other emergency savings.
Based on the above, although the short-term loan may appear expensive at an interest rate of 10%, the opportunity cost of paying off that loan then becomes the interest you could have earned if you invested the funds in the fixed term deposit.
This example is, of course, simplified but in real life, there are always more factors to consider.
Given the current increases in interest rate and inflation, are your investments still generating enough return to offset the increasing costs of servicing the debt you have?
If not, you might have homework to do to ensure your choice of investment is still appropriate.
For more, check out our YouTube channel Money matters with Budget Bee- Namibian Youtuber to learn more on the subject.
*Klestina Kauhondamwa is a Chartered Accountant by profession
