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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