The Real Cost of Debt

In one way or another, everything has an associated cost. In economics, we refer to opportunity cost as the associated cost of choosing something else instead of another given option.

Debt has a tangible and quantifiable cost there is no doubt about that. So, we all know that debt has an associated cost with it (interest rates, origination fees, etc.) but there is a true cost of debt that not many people are actually aware of. The real cost of debt is more than just the interest rate and the monthly payments you have going out to creditors. The total cost of debt arises from opportunity cost and the alternatives you missed out on.

What if we had chosen a different alternative instead of servicing this debt? When we service debt, we pay it off with our hard-earned income and that income could’ve went somewhere else if we didn’t have the debt.

Opportunity Cost

The opportunity cost is what we could’ve did with our money instead of it being wasted on interested payments.

For example, if we were paying $200 a month on credit card debt, if we were able to pay that debt down sooner and instead use that money for investing, we would also have missed out on an investment return.

So, on paper, we missed out on $2,000 we spent on interest, but maybe we also missed out on a 10% investment return which would equate to $240 over 12 months if we considered a 10% yearly rate of return.

So, the real cost of debt is actually going to be much higher than what we can see on the surface level. We are not only losing time and money spent on interest, we are also foregoing the potential use of our money somewhere else. This is true with every purchase we make in life.

Had we instead invested that money, it would have generated more money in the long term and if we were not able to invest it, we miss out on those potential gains.

In other words, carrying debt in excess can cost us a lot of potential missed investment gains or leisurely spending. If the capital was readily available to us it would’ve helped us make more money and accrue more assets in the longer term.

Everything has a cost when it boils down to it but that cost can sometimes be a little hard to measure. Moreover, we don’t technically know what our potential loss of investment gains would’ve been since we did not technically invest that money. Otherwise, this isn’t something that we can make a prediction about without knowledge of future returns (which would be impossible to get).

Prioritize Paying Down Debt

This is why it’s essential we prioritize paying down debts. There’s no way around it, when we carry a lot of debt, we are throwing money away towards interest and then losing out doubly, since we could’ve used that money somewhere else or for something else.

Debt always has a cost, whether it’s an auto loan a mortgage or a personal loan.

Auto Loans

Auto loans are going to be your best bet to acquire the capital to buy a car. Unless you are paying all cash, the auto loan will be amortized over a 3-6-year time period (usually) although that all depends as well. Depending on your credit rate and the current market rates, you can sometimes get a good interest rate on an auto loan or if there are any promotions going on. However, be aware there is a cost associated with promotional interest rates. The promotional interest rates are not always a free gift and the cost can sometimes built into the terms of the loan in other ways. It’s important to check all charges and fees and try your best to make sense of them.

Mortgages

Mortgages are going to have a cost like anything else. They are great for acquiring a home and the rates will be lower than others since they are secured loans but at the end of the day, consumers will still pay back multiples of what they borrowed for the life of any given mortgage.

Let’s put forth an example of a 7% interest rate mortgage with a 30-year term. If you were to for example borrow $300,000, the mortgage could end up costing you over $1 million dollars by the end of the repayment period. This associated cost is there but it might not always be apparent. It’s important to ask for a payoff later on the mortgage to understand how much of your payment will be going towards interest and how much you will actually pay in interest by the end of the mortgage. If you ask your lender to furnish a payoff letter they will provide one for you. This will be a real eye opener to just how much you’ll pay to eliminate the debt and it’s always recommended you ask for one when you apply for a mortgage!

Personal Loans

Personal loans all have an associated cost. These loans have an origination cost and they typically will have a higher interest rate than an auto loan or mortgage. All unsecured loans (like personal loans) will tend to have a higher APR than a secured loan like a mortgage or an auto loan.

In Conculsion

The opportunity cost of taking out an unnecessary loan is quite significant! Anytime you take a loan out for a “want”, you are choosing not to do something else with that money. Now that doesn’t mean don’t ever go on vacations. However, if you spend $5,000 on a vacation, you could have easily invested that money instead. That $5,000 could have doubled in 5 years. So, the real cost of the vacation could have been $10,000 in 5 years.

Although, this is ultimately an unknown. The example of $5,000 could have had a much higher cost than meets the eye. Losing out on money like this, especially to pay interest on debt (especially if it’s unnecessary interest) is a real big financial no-no. It takes away from potential investments and other scenarios where we could have made money instead of wasted it on interest. And for a consumer that is struggling financially, that’s not something we want to be doing!