When it comes to accessing other people’s money, it’s clear that capital has a cost. For example, when we have a credit card debt, we know that we’re paying a lot of interest towards that debt. Same thing with student loans or mortgages or any other debt.
However, a lot of people fail to remember that our capital also has a cost. And we call that opportunity cost. The cost of not investing that money and spending that money instead has a cost. And that is what people fail to recognize.
It’s easy to forget that our capital actually has value when we have it in the bank earning next to nothing. However, if that money was invested, what could that money be earning for us? What if we took advantage of an opportunity in business or an investment or anything else? We would be earning an external rate of return on that money that we couldn’t earn within the banking system.
And you see, the important point here is having access to capital. When you have access to capital, opportunities will seek you out.
I’d argue that all financial stress actually comes from not having access to money when we really need it. So that’s why a lot of people save in the bank. We have access to that money, there’s no penalties, we may not be earning any interest, but at least we could get our hands on it if we need it.
The point is that safety of principle and accessibility to your money has a cost. One of the biggest mistakes that we see people make, whether it’s on a business basis or a personal basis, is not recognizing the value of their own capital. They completely ignore the value that their own capital or accessing their own capital has to them as an investment.
We talk about this all the time, continuous compound interest. You not only lose that money, but you also lose the potential that money could have earned you if you had left it invested. That’s called opportunity cost and it’s amazing how seemingly smart and great financial people completely ignore opportunity cost.
But it makes sense. I mean, conventional wisdom tells us that debt is bad and that cash is king. What you expect from them? However, conventional wisdom may not have our best interest in mind.
Another thing that we found is that people obsess over what they see. In other words, I’m not going to pay 8% to a bank in order to borrow money to buy a car. I’ll pay cash and pay nothing. Again, they obsess over what they see. The 8% they’re paying, but they completely ignore what they don’t see, what their cash could have earned them had they not paid cash for the vehicle? We accept as normal what the system has conditioned us and taught us to accept as normal whether or not it’s true.
Here’s a perfect example. Let’s assume you have $25,000 sitting in a bank account, a savings account, earning 4% interest. Now, I know they don’t exist today, but just go with this example. You want to buy a car, You need to buy a car. And the car coincidentally cost $25,000. So you say to yourself, I don’t want to cash in this account because I don’t want to lose that interest rate. I’ll call the bank.
So you call the bank and you find out that the car loan will cost 6% interest. So now you’re thinking, okay, if I pay 6% interest, that’s 2% more than the value that I could earn in my savings account at 4%. I’m not going to pay 6% interest. I’ll cash out my savings account and give up the 4%.
But the banker says, Oh, no, no, no, no. It’s actually going to cost you less to finance at 6% and your account will grow by more earning only 4%. Do you believe him?
Now, think about that. You mean to tell me I’m going to earn more money at 4% versus paying 6%? That doesn’t make sense. But the numbers are true.
The $25,000 in your bank account earning 4% is compounding the interest is being accrued on a growing balance. So at the end of five years, because that’s how long typically a car loan is, your account balance is going to be $30,524 and some pennies.
Now, conversely, if you finance the vehicle, borrow $25,000 at 6% interest for five years, the payment is $483.32. And if you add up all the payments for 60 months, it’s going to equal $28,999 and change. That’s what you’re going to pay. And you could have earned 30,524 and that’s what you would have had had you not paid cash.
It’s a bit of a paradigm shift. But the point of the matter is that your assets have value, whether you’re taking advantage and earning interest on them or not. It’s important to put your money somewhere where it’s safe. You have full liquidity use and control of your money, so you’re able to take advantage of continuous compound interest on your money.
But again, it’s really simple to obsess over what you see, paying 6%, and completely ignoring what we don’t see, the interest that we would have earned had we not paid cash. And we always say, you’ll never see the interest you don’t earn.
If you’d like to learn more about our process and how we put it to work for our clients so you’re able to make better financial decisions, visit our website at Tier1Capital.com to schedule your free strategy session today. Or if you’d like to learn more about exactly how we use this process to help our clients, check out our free webinar, The Four Steps to Financial Freedom found right on our home page.
And remember, it’s not how much money you make. It’s how much money you keep that really matters.