Opportunity Cost

Opportunity cost is the value of the most valuable alternative you give up when you choose one option. If you spend an evening on one project, the other project waits. If you use $10,000 of savings to pay for a car, whatever that $10,000 would have earned where it sat, and the comfort of having it on hand, is gone until you rebuild it.

It is not billed, and it does not appear as a line on any statement, so it is easy to leave out. That is the reason to learn it. A comparison is not finished until the alternative is named, priced after tax, and set beside your choice over the same period.

What is the meaning of opportunity cost?

Economists define opportunity cost as the next most valuable alternative forgone. Each word does work. Alternative means a real choice that was open to you. Next most valuable means the most valuable of the options you did not take: not all of them added together, and not the weakest one. Forgone means you gave it up by choosing what you chose.

It is not only about money. Time has an opportunity cost: an hour on one task is an hour not spent on another. Attention has one. So does flexibility, because a commitment that closes options has cost you those options whether or not any money moved.

Illustrative example, with round numbers and no real product behind them. You commit $10,000 to something you expect to earn 6% over the next year. The most valuable alternative open to you would have earned 9% over the same year, at similar risk and with similar access to the money. The difference is 3 percentage points, or $300 in the first year.

Strictly, the opportunity cost of your choice is the whole value of the alternative, $900 in that example. The $300 difference is the figure the formula below produces, because it answers the practical question: was the choice worth it? A choice is sound when what it gives you is larger than what you gave up.

What is the opportunity cost formula?

In money terms, the formula is short: opportunity cost equals the result of the most valuable option not taken, minus the result of the option taken.

It looks like simple arithmetic. It becomes useful only when three conditions hold.

1. Same amount and same period. Compare $10,000 with $10,000, over one year with one year. A five-year result set beside a one-year result tells you nothing.
2. After tax and after fees, on both sides. A return that is taxed and a return that is sheltered are not the same number, even at the same rate. Take costs off both options, not only the one you are arguing against.
3. Similar risk and similar access. A contractual value set beside a market return, with no adjustment, compares two different things. So does money you can reach tomorrow set beside money locked up for a decade.

Get the conditions right and the arithmetic takes a minute. Get them wrong and the formula will flatter or condemn any decision you like, because the number is only as good as the alternative chosen, and the alternative is chosen by whoever makes the argument.

How do you calculate opportunity cost with Canadian tax in the picture?

Illustrative example, with hypothetical rates rather than current market figures: one year, $10,000. Assumptions: you have a car loan at 6.5%, and because the car is personal, its interest is not deductible; you have unused TFSA room; your combined federal and provincial marginal tax rate on interest income is 30%; savings earn 3% before tax. The balances are held level for the year to keep the arithmetic plain.

Read the table in both directions. If you prepay, the most valuable alternative you give up is the TFSA's $300, and prepaying comes out $350 ahead for the year. If you keep the money in the TFSA, you give up $650 of interest saved, and the $350 gap is what you pay that year to keep the money within reach. Neither answer is wrong. One buys a lower cost; the other buys access.

Change one assumption and the answer moves. Interest on money borrowed to earn income from a business or property can be deductible, and the Canada Revenue Agency's Income Tax Folio S3-F6-C1 explains that the test looks at how the borrowed money is used. That rule does not make a personal car loan or the mortgage on your own home deductible. Quebec residents also file a Revenu Québec return, so the rate to use is the combined federal and Quebec rate. An accountant can put your own marginal rate in the row.

What are the types of opportunity costs?

Two parts make up the economic cost of any choice, and only one of them shows up in the accounts.

The full economic cost of a choice is the sum of the two, measured against the most valuable alternative. An accounting statement shows only the explicit part. That is how a business can report a profit and still lose ground: if the owner's time and capital would have earned more elsewhere, the business is profitable on paper and costly in fact.

Households carry the same two layers. The interest on a line of credit is explicit. The earnings you give up when you drain savings to avoid that line of credit are implicit. Both are real, and a fair comparison counts each of them once, without counting the same effect twice.

What is the difference between opportunity cost and sunk cost?

This distinction earns its keep every day, and it is easy to get backwards.

Opportunity cost looks forward: what do I give up by choosing this? Sunk cost looks backward: what have I already spent that I cannot get back?

Money already gone is gone whatever you choose next, so it should not steer the next choice. The opportunity cost of the next choice is exactly what that choice decides, so it should.

The trap runs the other way. People stay in a losing position because of what they have already put in, and never price what staying will cost from here. A renovation half done, a course half paid for, a car that keeps needing repairs: the question is what each path costs and delivers from today, not what it took to get here.

Is opportunity cost the same as real cost?

Some economics texts use "real cost" to mean opportunity cost, because both point at what a decision truly costs rather than what an accountant records.

In Canadian personal finance writing, "real" also has a second meaning: adjusted for inflation. A real return is the return left after inflation. When you read either phrase, check which sense the writer intends before you compare any numbers. A comparison can go wrong by ignoring the alternative, or by ignoring inflation, and the two mistakes are different.

Is there an opposite of opportunity cost?

There is no standard opposite. The natural contrast is the benefit of the option you actually chose, which some writers call an opportunity benefit. The label matters less than the test: a decision is sound when the benefit of what you chose is larger than the opportunity cost of what you gave up.

Counting only the benefit invites you to stop there, satisfied. Naming what you gave up forces the comparison to be finished. That is why promotional material leans on the benefit side, and why a careful comparison shows both.

What does paying cash really cost?

R. Nelson Nash, who first described the approach set out in his book Becoming Your Own Banker®, made the point in Part I, Lesson 11: you finance everything you buy. Either you borrow and pay interest to a lender, or you pay cash and give up what that money would otherwise have earned. Only the first cost shows up on a statement. That is why paying cash feels free, and is not.

Take a car. Finance it through the dealer's lender and part of every payment is interest that goes to that lender. Pay cash from savings and there is no lender and no bill, but the money is no longer earning whatever it earned, and it is no longer there for the next emergency or the next opportunity. Until you rebuild it, that is the cost. It can be smaller than a loan's interest. It can also be larger, if rebuilding takes years, or if the empty reserve pushes you onto a credit card when something breaks.

So the question is never simply "finance or not". It is "through whom, at what cost, and with what effect on my capital". Why Nash said your premiums should match your income follows that thought further, and paying for a vehicle prices each route for a real purchase.

One fact belongs beside every route: who receives the interest. Interest paid leaves the household and does not come back, whoever receives it. A bank, a credit union or a dealer's lender keeps the interest on its own loan. On a policy loan, the insurer lends and the insurer receives the interest. Paying from savings involves no interest at all, which is exactly why it is the alternative every other route has to beat.

What does it cost to hold savings while carrying a mortgage?

It costs the gap between what the mortgage charges and what the savings earn after tax, paid every month in exchange for having the money within reach.

Illustrative example. Assumptions: $20,000 of savings in a non-registered account earning 3% before tax; a 30% combined marginal rate; a mortgage at 5%; a prepayment the mortgage allows without penalty. The savings earn $600, or $420 after $180 of tax. Prepaying $20,000 would avoid about $1,000 of interest in the first year. The gap is about $580 a year, and that is the price of keeping $20,000 available.

Three Canadian details change the picture. Mortgage interest on your own home is not deductible, so the full rate counts. Interest earned outside a TFSA or an RRSP is taxed. And how much you can prepay, and when, depends on the prepayment privileges in your mortgage. A Canadian mortgage is amortised over many years, but its rate is set for a term and then renewed, so the rate you are comparing against can change at renewal.

Whether the gap is worth paying depends on the household. Money inside a mortgage is hard to get back out; money in savings is not. A household that sends every spare dollar to the mortgage and keeps no reserve has solved the arithmetic and created a liquidity problem. The first surprise bill may then land on a credit card at a far higher rate than the mortgage ever charged.

Does unused TFSA, RRSP or FHSA room cost you anything?

The room itself follows different rules in each plan, so name the plan before you answer.

• TFSA. Unused contribution room carries forward and is added to the next year's limit, and the Canada Revenue Agency adds withdrawals back as room on January 1 of the following year.
• RRSP. Your deduction limit starts from your unused RRSP deduction room at the end of the preceding year, so unused room carries forward.
• FHSA. The carryforward is limited. The CRA caps the participation room carried into the next year at the lesser of $8,000 and a formula, and total contributions are capped at $40,000. At most $8,000 of unused room carries into the next year; room above that is lost.

What can be lost for good in every plan is time. Money that could have grown sheltered for five years, and did not, cannot get those five years back through a larger contribution later. That growth is not certain, though. It depends on what the money would have been invested in and how those investments did. The opportunity cost is real, and its size is unknown until you name the investment.

Whether contributing is right for you depends on your income now against your income later, your other obligations, and what else the money would do. These plans and a life insurance policy do different jobs under different rules, and this practice gives no ordering between them. Put registered-plan questions to a professional licensed to advise on them. The habits behind these choices are covered in why personal finance is important.

How do you tell whether an alternative is honest?

The alternative is where an opportunity cost argument is won or lost, and it is chosen by whoever makes the argument.

Against a savings account paying little, almost anything looks good. Against a diversified portfolio at long-run averages, almost nothing does. The same decision can be made to look excellent or dreadful purely by the choice of comparator, and no arithmetic stops it. Four tests help.

1. Would you actually have done it? Not could have: would have. A comparison against an investment you would never have made is a comparison against a fiction.
2. Was it available to you? An alternative that needs capital you did not have, or access you do not have, is not an alternative.
3. Does it carry the same risk and the same access? If not, adjust for the difference or say plainly that you have not.
4. Were costs and tax taken off both sides? Watch for the one-sided adjustment: fees and tax deducted from the comparator and not from the thing being presented, or the reverse.

An argument that fails any of the four is using opportunity cost as rhetoric, not as analysis.

Why does the length of a commitment matter?

Commitment is a cost even when it is not a payment. The longer capital is committed, the longer you give up its other uses, including uses you cannot foresee today.

Length alone does not set the size of the cost. That depends on the amount, on what you could realistically have done instead, and on the risk and access of each choice. Two arrangements with the same stated cost are still not equal if one ties up capital for ten years and the other lets you walk away next month.

The failure shows up at the worst moment. A household that needs money during the locked period solves the problem by borrowing, and that borrowing cost belonged in the original comparison. Before any long commitment, ask what happens if you need the money in year two, year five and year ten, and get the answer in writing.

Is the cost of waiting an opportunity cost?

Yes. Deferring is itself a choice, and it gives up whatever the alternative would have produced during the delay. Where something compounds, delay costs the compounding that would have occurred. Where something is priced on age or health, as life insurance is, delay can cost the price that was available.

That is not an argument for hurry, and anyone using it that way has turned the concept upside down. A decision measured in decades does not improve for being made this week. The cost of waiting is one fact to weigh against the cost of deciding badly, and deciding badly can be the more expensive of the two.

Attention has an opportunity cost too. A household that spends months fine-tuning a small decision while a large one goes unexamined has paid it: the visible decision got the effort and the consequential one got a default.

Where is the concept misused?

Opportunity cost is easy to borrow to make a weak argument look rigorous. Three patterns are worth knowing.

• The unstated alternative. A claim that something "costs you" a return, with no word on what would have produced that return. The number looks like analysis and rests on an assumption nobody has examined.
• The long-run average applied to one life. Market averages describe a long run. A household investing for thirty years lives through one particular sequence of returns, not an average, and a comparison built on the average can overstate what the alternative would have delivered for that household.
• The one-sided adjustment. Fees, tax and access counted on one side of a comparison and left off the other.

Each of these produces a number. None of them produces an answer.

How does opportunity cost apply to a policy loan?

Applied honestly, the concept cuts both ways, and it should be applied here as firmly as anywhere.

The case made for using a specially designed, high-cash-value, participating whole life insurance policy to finance purchases is, at heart, an opportunity cost argument: interest paid to an outside lender leaves for good. That observation is sound. The comparison attached to it can be weak. It sets a loan from an outside lender beside a policy loan, when for many households the honest alternative was not borrowing at all. It was paying from savings, which costs no interest. Against that alternative the advantage shrinks, and whatever remains has to be earned in other ways.

Two debts are easy to blur, so name them. On a policy loan, the owner owes the insurer. If the owner then lends that money to a relative, a second debt appears: the relative owes the owner. Neither is money you owe yourself.

The policy has its own opportunity cost as well. It is life insurance first: premiums committed for many years, and guaranteed cash values that can sit below the premiums paid in the early years (the guaranteed column of your illustration shows it, and cash surrender value explains how to read it). A household with no lasting need for life insurance, or without a steady surplus and an emergency reserve, may be better served by other tools, and saying so is part of an honest comparison.

Tax belongs in the comparison too. Under the Income Tax Act, a policy loan is a disposition of an interest in the policy (s. 148(9)), and only the part of the loan above the policy's adjusted cost basis just before the loan is included in income (s. 148(1)). A loan from another lender, secured by an assignment of the policy, is not a disposition. When a policy loan becomes taxable sets out the rules; your accountant applies them to the insurer's figures.

What, then, can a policy change? Not the fact that borrowing costs interest: the insurer lends its own money and is paid for it. What it can change is where capital sits between purchases, and the terms on which you can reach it. Depending on the contract, a policy loan can be requested up to the loan value the contract sets, without a new credit application. Repayment follows the contract's terms rather than a lender's schedule, which is a freedom and also a risk, because unpaid interest can be added to the balance. Ask for the loan provision of your own contract in writing, because the contract governs.

That is the question behind the approach this practice calls Infinite Financial Sovereignty®, a registered trademark of Jose Salloum: a comparison that prices every alternative except the terms of access to capital has left out a term. Whether that access is worth the policy's cost is a genuine question, and the answers against it are set out in objections and risks. How policy loans work gives the mechanics. Reading any of it costs nothing; if you later buy a policy through Canadian Wealth Creation Centre Inc., the firm is paid a commission by the insurer.

How do you use opportunity cost in a real decision?

Four questions, and none of them needs a professional.

1. What is the alternative, named specifically? Not "something else": the actual thing you would otherwise do with this money or this time.
2. What would that alternative have produced, after tax, on assumptions you would defend to a sceptic?
3. What does this option close off, and for how long? Commitment is a cost even where it is not a payment.
4. What am I ignoring because I have already spent it? That is the sunk cost question, asked on purpose, because it will not come up on its own.

Then put both options side by side in a short worksheet before you decide.

The same method, run on real purchases with every route priced, including the one this practice sells, is on paying for a vehicle and the down payment. The rows where the policy loses are named there too.

When a comparison involves a registered account or borrowed money, read the rules at the source: the Canada Revenue Agency's page on the Tax-Free Savings Account sets out contribution room and withdrawals, and its page on carrying charges and interest expenses explains when interest on borrowed money is deductible. Those rules change the after-tax figures on both sides of the comparison.

What is the one habit worth keeping?

Every choice about money is a choice against something else, and the something else does not write itself down. Naming it before you decide is the whole discipline. A decision compared against nothing has not been compared.

Apply the question to every claim you meet, including the claims made on this site. Applied honestly, it will sometimes show that the alternative was better, and that is the point of learning it. The other ideas underneath money decisions, explained the same way, are in money principles.

Figures are illustrative round numbers, not projections of any actual arrangement. All amounts are Canadian dollars.