Explain the relationship between mortgages and opportunity cost. |
There is another little understood or communicated concept to consider concerning the interest transferred to the bank. This concept is known as opportunity cost. I will explain by telling you my rich aunt story. Suppose you just purchased a house for $100,000 and have yet to make your first payment. Your rich aunt, (this is fictitious of course) cashes in one of her jumbo CDs and wants to pay your mortgage off. She wants to watch you enjoy the money while she is still living. You decide that since you do not have to pay the monthly note on the house that you are going to save that monthly amount. At the end of 30 years you would have $264,155 if you had simply put the money under your mattress. But we know you wouldn’t do that. You would invest the money. If you had invested the monthly payments and averaged an 8% rate of return, at the end of 30 years you would have $1,093,572. That is what it actually cost you to live in the $100,000 house and finance it for 30 years. What the interest could have earned had you not had to give it away is know as opportunity cost. The interest transferred away really cost us the difference between $1,093,572 and our principal amount of $100,000. There were some tax deductions along the way, but I think you get the point. It costs a lot of money to live in this house. An interesting thing to note here is that a lump sum of $100,000 compounded at 8% for 30 years would also produce $1,093,572. Had our aunt just given us the money and we had invested it, we could possibly have over a million dollars in our right pocket in 30 years. But, if we assume there is no aunt, we would have lost the same amount out of our left pocket. An interesting point is that the house costs us the same whether we pay cash or finance. We are going to transfer money away no matter which option we choose. The key is to pick the option with the least wealth transfers. We will consult the Mortgage Master for complete details. |
Opportunity cost of the mortgage is a Time Value of Money Future Value calculation with the following inputs: •Rate: Monthly Opportunity/Investment Rate of Return. •PV: 0. •Periods: Loan term in months. •Payment: Calculated monthly loan payment •Payment at End of Period. |