Sunday, February 26, 2012

Weighing the Opportunity Cost

Debt management or getting out of debt is one of the firsts to do’s in making one’s personal finance better.  For the last couple of months, I have heard of friends who are down with debt and are troubled on how they can make both ends meet.  As they say, never pay a debt with another debt, otherwise you will just end up yourself circling around in just the same roller-coaster ride.

Increase your cash flows
Increasing our cash flows is a first step to pay off debts.  How? There are a number of simple ways, like getting into sideline business (ie: prepaid e-load cards), part-time jobs, the likes.

Your additional cash flows can be used either to:

  1. Put money in your savings account or emergency fund;
  2. Put into long-term savings, equity investments, mutual funds or retirement fund;
  3. Put up business or real estate investments;
  4. Pay-off debts

Building trust by paying your debts
Let me focus on the bullet #4, which is to pay-off debts.  Most of the time, people tend to “forget” the debts that they owe to other person when they have enough cash on hand –which will really create a bad impression because this means that you are not trustworthy enough to give the money back to the one who lends you during those time you need it most.

Trust, in every relationship, (yes even in debtor-lender relationship) plays an important role.  You may have money now, but there comes a point that when you’re in the brink of needing extra cash again, nobody will lend you because you were not faithful enough to pay it then.  Do you think you will be able to borrow money again? I doubt it.

Long-term savings VS Debts
Let me elaborate on the itsy-bitsy technical side now.  When one got extra cash, either it will be put on long-term savings or pay-off a big chunk of debt, or both.  Let me illustrate an example so we can understand it better:

Let’s say you have:

  • An extra Php10,000
  • A debt worth Php100,000 charging you 8% interest a year, payable 10 years. 
  • Then, a possible long-term investments that can provide you with 20% income a year. [Whoopie!]

weighing opportunity cost

Opportunity cost
Let us do the calculations (my favourite part. Hehe. I love Mathematics, by the way): ^_^

  • If we put into investments our Php10,000, earning an approximately 20% a year, this gives us Php2,000 annual income.  However, our debt of Php100,000 x 8% = will charge us Php8,000 interest expense annually.
  • If, on a different scenario, we used our Php10,000 to pay off our debt of Php100,000 = then only Php90,000 x 8% = Php7,200.  This gives us Php800 savings [Php8000 – Php7200], but we lose the Php2,000 income had we decided to invest our money.
  • What is our net opportunity cost? It’s Php2000 income less the Php800 savings from interest expense = Php1,200 income that we lose.

So, what’s the lesson learned? Don’t pay your debts! Hahaha.. just kidding. Smile with tongue out

We also have to consider the time.  Our income from investment of Php2,000 would give us Php20,000 in 10 years time.  However, our Php100k debt will give us Php80,000 interest expense! (Ouch!)  Our income of Php20k is not even enough to pay off the interest expense of Php80k!  If we decided to pay off our debts with our annual savings of Php10,000, then in 10 years time, we had washed off our debts (please also consider that the debts diminish when you pay it yearly, hence your annual interest expense also goes down.)

So, what’s the REAL lesson? (^__^)  It’s TIME – when we know how to make good use of time and make it to our advantage, then we would know how to be able to make better decisions.  If you also have a quest in managing your personal finance for the better, never be afraid to work on with the numbers. Open up your MS Excel and play with the computations and do sound better judgment, rather than making decisions here and there, and just be carried away by our emotions. ;)


Keep learning and keep moving forward!

Lyn-Lyn _(“,)/

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