What are opportunity costs?
Every day, you make choices. You choose what time to wake up, what to eat for breakfast, what tasks to accomplish at work, and so on.
Whenever you choose to do something with your time, you are essentially saying no to everything else.
The same thing is true when it comes to choosing where to spend, save, or invest your money. If you choose to spend $30,000 on a new car, and you pull that money out of your savings account, you no longer have that money available. However, not only did you lose access to $30,000, but also the interest those dollars could have earned. Let’s see what the numbers look like over 30 years.
For this example, say your money is earning 4% interest in some type of savings vehicle. Over 30 years, $30,000 earning 4% compounded annually would be just under $97,302. That’s $67,302 of interest earned.
By withdrawing $30,000 to pay for a new car, you miss out on earning more than $67,000 over 30 years.
Now that’s an expensive car! And that’s opportunity cost.
You are thinking, “Ok, sure, but I need a car in order to get to work, get the kids to soccer practice, take vacations, and for lots of other reasons.” And, you are right.
Nobody is suggesting that you save every penny you earn and never touch it. That’s impossible. But, there is a better way to manage your cash flow in order to keep more of your money over time and still cover down on life’s expenses.
Back to the $30,000 car. Let’s examine three different strategies:
- Don’t save anything, obtain financing to drive the cars you want, divert your cash to the banks, and never have any money.
- Save. Build up enough savings, then withdraw and pay for cars with cash. Replenish savings to the same level as before.
- Save and leverage. Build up savings, continue to save regularly, then leverage that cash to make your car purchases.
For all three examples, assume a 4% interest rate that could be earned on your money and 4% financing costs. Also, our hypothetical car purchaser is in the 22% tax bracket, which will come into play when choosing where to store cash.
Over 30 years, the hypothetical consumer might want to purchase six cars, or one every five years.
Using strategy #1, the car buyer would have no money in the bank and would have paid over $202,000 to the bank over 30 years. That’s $180,000 for the cars and over $22,000 in interest.
This is the result one would expect using strategy #1, and sadly, this is how a lot of people go through life.
Things get a lot better with strategy #2.
The difference here is that someone would have to save up the $30,000 first, before being able to pay cash for the car.
But this method provides superior benefits to the person disciplined enough to be a saver.
After 30 years, this individual has almost $270,000 in the bank and still enjoyed a new car every five years.
On to strategy #3. What happens when our car buyer decides to finance a car from the bank instead of dipping into savings?
To do this, an extra $739 per year above the $6,000 that our cash buyer had to find would go towards the car payment. However, at the end of 30 years, this person would have over $291,000 in the bank, an increase of more than $20,000!
While strategy #3 produces the highest bank account value at the end of 30 years, what could make this scenario even better?
What if the vehicle used to store savings allowed these dollars to accumulate tax free?
If the 22% tax is removed from the calculator, this person would have over $336,000 at the end of 30 years.
That’s an improvement of over $45,000 from strategy #3 and $65,000 greater than strategy #2.
Even better, if this person used a whole life policy to build up cash reserves, there would be many additional benefits beyond the tax free growth, including the ability to use the money tax free.
Whole life insurance is not an investment. But when it is positioned as your foundational asset, a tier one asset, it gives you more options and offers control over your money.
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The hypothetical examples above are meant to provide a better understanding of different financing strategies. Each person’s financial situation is unique. Speak to a trusted, financial professional before implementing strategies such as the ones presented here. All calculations performed using TruthConcepts financial calculators (www.truthconcepts.com).