Q. My husband Tom and I follow your podcast. He is a car mechanic and told me he wants to buy new handlebars for his motorcycle. It will cost $1800 because it involves additional parts. The funny thing is, he plans to sell the motorcycle! I reminded him about opportunity cost. What more help can you give me to explain why he shouldn’t buy this?
Thank you, Sue
A. Sue, I appreciate your email and that you and your husband are listeners! Thank you for that. You did the right thing to remind him about opportunity cost. Here’s the deal: putting $1800 handlebars on a motorcycle you plan to sell is like flushing that money down the toilet. You won’t get it back when you sell the bike because someone else probably won’t appreciate the new handlebars to pay $1800 more. As long as the motorcycle operates well and looks nice, a buyer will want to pay the lowest price they can. They’ll look at comparable bikes with similar mileage and see what they are selling for and that’s what they’ll offer you.
I’m glad you brought this up, because it gives me a chance to delve into opportunity cost deeper and more importantly, how to prioritize your spending and investing needs.
One of the biggest lessons I learned from my parents is the need to invest on the side while you’re employed. As soon as you start making money, you should be saving for retirement. You can open an IRA with earned income and you should start putting aside a portion of what you earn immediately, even if it’s only a few hundred dollars. I have my first job as a lifeguard at age 16, that’s when I should have started putting 10% into an IRA. The earlier you start, the bigger the difference because of compounding.
But, back to your question. Let’s look at the opportunity cost of $1800. Look at MoneyChimp.com and calculate how much $1800 would grow to at 8%, the historical rate of return of the stock market.
According to MoneyChimp, that would grow to $8,390 in 20 years and $18,112 in 30 years. So there’s a real value to each impulsive purchase decision like Tom’s that we make.
Let’s take this a step further. Let’s look at how to analyze whether or not this is a smart purchase. We’re going to do that by prioritizing how we spend money so that it is spent on the things that matter to you, not things that are impulses and don’t really mean anything. That way your money is going toward the things you value and away from the things you don’t value.
When we look at your financial obligations, they are the same for just about everyone:
1. Home/shelter
2. Food
3. Kids
4. Retirement savings
5. College savings
6. Transportation
7. Utilities
8. Insurance
9. Clothing
10. Entertainment
These are the 10 basic expenses everyone has. If you don’t have children, then obviously the categories of kids and college don’t apply to you, but everything else does. Notice I didn’t put elective items like “travel” on the list, because it’s elective. These are the 10 basic things you pretty much have to spend money on.
Now, what do you value and want to spend money on? In other words, what would you choose to do with extra money?
Maybe you enjoy playing golf, so the “entertainment” category is a bit more expensive for you. You’re buying golf clubs, paying green fees or paying for a club membership, etc. If that’s what you enjoy most, then you should have your money going there.
Let’s say you’re on vacation in Mexico and go to a presentation about a time share. You get the idea you should buy one. After all, $10,000 seems doable to you and they convince you that you’ll save money by doing this.
You weren’t thinking about buying a time share before, this is a total impulse purchase. You can rationalize all the reasons why it would be so great…great to take the kids or just the two of you, you have luxury accommodations, it can cost less per might than a hotel, etc.
Before you make this purchase, let’s see where it fits into your priorities. It would fit into the “entertainment” category.
But above that category are the college savings and retirement categories. You might be a worrier about how you’re going to pay for those, but they seem far into the future, and the timeshare is something you can enjoy now, so why not go for it? Life is short, you rationalize.
If you take the view of “today” over “the future” you’re adding stress to your everyday life because you will continue to stress over paying for college and paying for your retirement, which you know will come someday in the future! But the attitude of living for today will get you to spend the money every time. So what can you do?
I’ve mentioned this in the past, but the secret is to keep one eye on today and one eye on the future. That means you don’t want to do things just for today and not for the future. You want to do both. When you have that philosophy, you can make a decision that is balanced. So perhaps using that strategy you don’t buy the timeshare, but you do agree to take a vacation annually and to save for it in advance each year. It will still cost you less than the timeshare because of opportunity cost.
So what is the opportunity cost of the timeshare? Well $10,000 at 8% for 20 years is $46,609 and for 30 years is $100,626! So that $10,000 is better off being put into the college fund or the retirement fund! You’ll be less stressed because you’re reaching your long-term goals of retirement and college funding and you won’t have the additional annual fees of the timeshare.
So, back to Tom and Sue. Here’s what you can do to bring yourself back from the brink of impulse spending and into the realm of spending on your priorities.
1. Make a list of your spending priorities. Do this with your spouse so you’re on the same page. Start with my list of 10 items and break them down even further. You can break down entertainment into eating out, travel, TV, sports, etc. What is important to you and where do you want to spend money? If you like going to professional football games and having season tickets, then make that a priority.
2. When you want to make a purchase over $1,000 ask yourself where it fits into your spending priorities. Is it on the list? If it’s not, think about why you want to make that purchase.
Ask yourself these 5 key questions:
- 1. How will this enhance the quality of my life? If it won’t (I don’t think the handlebars pass this test) then pass on the purchase.
- 2. Will this extend my life, marriage, or health? Anything that will add to life, marriage and health should be a priority (however, be careful because you can justify things that you don’t really need. You might try to justify the time share is a “yes” here, when it’s really the annual vacation that’s a yes, not the timeshare).
- 3. What is the opportunity cost of this money? Calculate it by going to MoneyChimp.com, click on Calculate on the black bar, then put in the principal, rate and years. Click “calculate”.
- 4. Will this keep it’s intrinsic value and also increase in value over time? Again, be honest and realistic. Tom might think the handlebars will get him more money for his bike, but the reality is, they won’t.
- 5. Is this more important than my kids’ college or my retirement? The answer is usually “no”. But I’m not about deprivation, I’m about balance. So what is a compromise? How about if Tom didn’t buy the handlebars and sold the motorcycle like he planned, then reinvested the money into a fixer-upper car that he could have fun updating? That would provide a return on his investment instead of flushing the $1,800 down the toilet. That $1,800 plus the proceeds from the motorcycle could launch him in a new business that he loves and be lucrative at the same time.
- 6. Will this increase my net worth? Always having an eye on what can increase your net worth, will help you continue to build wealth and reach your financial goals and financial freedom. If you’re not building your net worth, you’re not becoming financially free, it’s that simple.
Good job Sue for writing in and asking a question. I’ll bet you didn’t expect this long answer! Thank you for letting me use this as an example of how to change your thinking and spending in a way that will bring you wealth instead of keeping you broke. It’s all about your priorities, balance and opportunity cost!
Speaking of net worth, keep yours moving forward by getting my “11 Quick Financial Tips to Boost Your Wealth”.
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