Have you ever delayed selling a stock because you wanted to wait until that stock’s price climbed back up to your purchase price? If so, you’re probably incurring a cost: opportunity cost is forgoing the next best investment. Sometimes that next best investment can be better than the one that you still own. For example, if your stock needs a 10% gain to get back to even so you can “feel good” about not losing money on that investment, then you may well be foregoing a 30% gain on another stock.
A PERSONAL EXAMPLE
I recently checked the market value of my childhood home that my parents had sold in 1977 for $250,000. On Zillow that house is now estimated to be worth about $4,430,000. Property values in Silicon Valley, California have appreciated significantly since the 1970s. When I told my dad about this, he said, “Wow, I wish I would have kept it.” My response was, “You would have made a lot more if that money had been invested in the stock market instead.” Back then the equity in the house was worth about $232,000 which when multiplied out by the S&P 500 returns for 43 years amounts to a present-day value of roughly $30,156,000. Therefore, the opportunity cost of keeping the house instead of investing that money in the stock market would have been enormous. Unfortunately, in my family’s case, we invested in neither.
RELEVANCE TO INVESTING
With respect to my own portfolio management, I always try to remain invested in the stocks that I think will do the best from now on. It makes no difference (other than having to pay taxes) whether a stock in my portfolio is showing an unrealized gain or loss. If I do not think that that stock will do better than my next best alternative, then I should make the switch immediately. Waiting to pull the trigger on the switch usually leads to a significant opportunity cost, unless, of course, I’m wrong about which stock will do better going forward.
PAYING OFF THE MORTGAGE EARLY: GOOD IDEA OR NOT?
I don’t know how many times I’ve heard people say to me that paying off your mortgage early is a great idea. I can’t even count how many times I’ve heard it. Yes, I understand that not having a mortgage can offer a feeling of financial security. I think many people like that idea, and there’s been many articles written about the subject. Some suggest that people should make a 13th mortgage payment each year so their mortgage gets paid off early. But is this financially efficient and optimal? Let’s have a look at the numbers.
There are two input numbers to consider in order to run a comparison of whether it’s a good idea to pay down a mortgage early.
- Loan interest rate: This is the annual interest rate on the mortgage.
- Investing return rate: This is the annual return that’s earned on an alternative investment.
Let’s use an example. A person has a new 30-year fixed amortizing mortgage with a 3.00% interest rate in the amount of $100,000 on a home worth $125,000. The monthly payments are $421.60 for the next 360 months so the total payments equal $151,776 of which $51,776 is interest. Now, here’s where those articles seem convincing. Who wants to pay that $51,776 in interest? That’s a very large sum of money! If you pay an extra $50 per month to your principal, you will save $9125 in interest and pay off your mortgage almost 5 years early. To many people this sounds great because it enables them to get out of debt early and pay a lot less interest for only an extra $50 per month. However, many people forget to consider the opportunity cost. The extra $50 per month is exactly the same as investing $50 into an investment yielding 3% per year. For people, who would take the $50 and instead buy a new pair of shoes perhaps making the extra $50 payment per month is a good idea. What about using the $50 to invest in the stock market?
Let’s say the best alternative to paying down the mortgage principal is investing $50 per month in an S&P 500 index with an average annual return of 12% (that was the actual historical return average of the S&P 500 since 1928). We need to look at investing $50 per month for a period of 25 years because in the early 30-year mortgage payoff option the loan was paid off after about 25 years. After investing $50 per month for 25 years (assuming that $600 is invested at the end of each year) at 12%, the total amount saved plus investment growth totals about $89,600. However, in this case, there will still be a $23,643 balance on the mortgage.
Let’s assume that the $125,000 home appreciates at 3% per year. After 25 years, the home will have appreciated to a value of $261,722. However, the value of the home after 25 years will be exactly the same regardless of whether the mortgage was paid off or not. The balance sheet summary comparison of the two scenarios (after 25 years) is shown in the table below.
| Result after 25 years of Paying Down Mortgage Compared with Investing in S&P 500 | Home Value | Mortgage Balance | S&P 500 Index Fund Balance | Net Worth |
|---|---|---|---|---|
| Pay Down Mortgage | $261,722 | $0 | $0 | $261,722 |
| Invest in S&P 500 | $261,722 | ($23,643) | $89,600 | $327,679 |
This example illustrates that ignoring the opportunity cost can lead to decisions that may sound great but are actually far inferior to other alternatives. In general, borrowing money at a low rate and investing that same money at a higher rate (that’s the fundamental principle that banks employ to earn profits) will generate wealth.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.