Monthly Archives: October 2011

Why Opportunity Cost Should Always be a Consideration in Your Financial Decisions

Let’s say that you are in a position where you have extra money to pay off your mortgage. Is it worth doing? The short answer is that it depends. To arrive at a good answer, you must consider the other opportunities that you have with that money.

For starters, there may be other investments available to you. I am not referring to the stock market or any other exchange traded security. These tend to offer low yields over very long periods of time. The historical return for stocks has averaged around 6% over the past 100 years. Therefore, if I had a choice between paying off my house versus purchasing stocks, I would rather pay off the home loan. In addition, the stock market is very volatile and returns can be significantly below their long term averages over 10 to 15 year periods. We are in such a cycle now. If the interest rate on my mortgage is 6%, then I will not likely gain anything by deploying the extra cash into stocks.

What if you had more opportunities than this? What if you were considering to start or expand your own business? Obviously, there is more risk to that. However, the return on your capital investment will likely be much higher than investing in securities. In this situation, the rate of return would be much greater than the amount of interest that you’re required to pay on the mortgage. In this case, you’re better off investing the money rather than paying off your loan.

The opportunity cost demonstrates that my returns are negative if I pay off my mortgage when I have better ways to invest the money. If you plan on starting a new business, home equity is much cheaper than most of the alternatives. SBA loans, in particular, consist of higher fees and higher interest rates. This is because it’s hard for lenders to value the collateral and default rates are high. When they take possession of the collateral after a default, it’s much harder to sell at fair market value than a residential property.

Lastly, depending on your tax situation, the true cost of borrowing may be below your interest rate. Since mortgage interest is tax deductible for most taxpayers, the tax savings could be factored into offsetting the amount you are paying in interest. Your tax savings depends on what tax bracket you’re in. So, if you’re thinking about paying off your home loan, definitely look at all your other opportunities first.

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Filed under Finance, Small Business

The Reality of Wheelin’ and Dealin’

Making deals sounds fun and exiting, right? Not so fast. If you’re survival always depended on making deals, how stressed out would you be?

Imagine you had a period of success. In fact, you had several months in which you had deals that gave you a surplus of money. Also, this was your only income from a business in which you owned. Therefore, you had no steady paycheck. Eventually, things tend to even out. You have a slow month or two. At first, you do not worry because you accumulated some extra cash from previous months.

Yes, you were stressed out a little bit at the very beginning. But things came together and money was flowing in. Then the dry spell came. Within the first month, you changed none of your habits and were not worried. You assumed that since you had some recent success, more deals must be around the corner.

Then the second month passes and things are still slow. You start to get nervous and begin to wonder when things will return to normal. You still have some money left so there is no need to panic yet. However, things start to get stressful. In the back of your mind, you start playing the ‘what if’ game. You ask what if I cannot make the mortgage payment or buy food a couple months from now. You wonder if the last few successful months were just an anomaly.

After considering that, you look at your average income over the last year. Not bad. But, what if you had a steady income and every two weeks you were guaranteed to get paid? It would seem like you got a raise.

If your income relies on your investments or by collecting commissions, you will not have a steady income. A steady income is simply worth more than making an equivalent amount that comes in bursts. It is also much more stressful.

This is a big reason why most successful investors place more emphasis on risk than on returns. Managing risk first will relieve much of the stress that comes from deal making. The more erratic your income stream is, the more cash you need to have as a reserve.

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Filed under Finance, Investing