Myths On Money

On special request, and in tandem with our post on opportunity costs, this posts takes a looks at the full cost of a college education.

The Direct Costs

The direct costs of attending college are generally fairly simple to calculate. Tuition, books, fees, etc are all examples of the direct costs. Just sum up your tuition for each semester, the amount you spend on books, your school fees, and any other cost directly associated with going to school and you know the direct costs of a college education. Anyone who’s been to college understands that these direct costs can be quite substantial.

The Opportunity Costs

Surprisingly, as costly as the direct costs can be, the opportunity costs of going to college almost always outweigh them; in fact, opportunity costs usually dwarf the direct costs by a huge margin.

How is that possible?

Think again about what opportunity costs are; they are the gain that you could have had. In the case of college, the largest cost is the lost opportunity to work full-time for several years. Suppose a young woman could get a job paying $13/hour working full-time. In 4 years, she could have earned $108,000 (before taxes). If she had gone to college, she would not have been able to work full-time, and would probably have had to settle on a very part-time job with poor pay. So, in this case, the opportunity cost of college is $108,000 minus the wages she could earn working part-time. So if you are going to college, or thinking about it, remember the opportunity costs. Don’t just try to avoid the direct costs; try to avoid the opportunity costs as well. Work full-time through the summer, or go to school through the summer to reduce the time you are out of work, etc. You will save yourself more in opportunity losses than you will in tuition.

The cost of NOT getting an education

Okay, so now that everyone is convinced that hey cannot afford to go to college, let’s look at the costs of not getting a college education. Basically, not going to school doesn’t really have any direct costs. No one charges tuition to people who are not enrolled in their school. However, there is an opportunity cost to not going to college. According to recent U.S. census findings, the average American who graduated high school but did not go to college earned approximately $25,000 a year less than the average college graduate. Over a typical working lifetime of about 45 years, that comes to about $1,125,000 in lost wages for the non-college worker (and that’s WITHOUT and interest!) So, you can see how it is far more expensive to not go to college than it is to go to college, in the long run.

What are Opportunity Costs?

Opportunity cost is an economic principle. The opportunity cost of an activity is the highest value alternative activity that you could perform with the same resources, and it represents an important portion of the total cost of any activity. They are well understood and utilized in the business world, but strangely are almost unknown to the general public. Basically, opportunity costs are what must be sacrificed in order to buy/make/obtain/etc any given thing. It’s important to keep in mind that EVERY activity and EVERY purchase has an opportunity cost.

Maybe some examples will help illustrate this important concept. A student in college pays more in opportunity costs that he/she does in tuition. The direct cost of going to college is tuition and books, fees, etc. The opportunity cost of going to college is lost wages for full-time employment during those years. Or think about buying a home. The direct cost is the cost of the mortgage and payments in interest. The opportunity cost is the loss of whatever you could have purchased instead of the mortgage.

Opportunity Costs in Action

Let’s consider one of my favorite examples of the impact of opportunity costs. Imagine our friend Bob walks into a car dealership. He has been good and has saved $10,000 for a down payment on a car. The salesman shows him all the latest models with all the hottest features. He finds one he really wants; but it comes with a price tag of $28,000. Ouch. The salesman has a slick deal for him, though. He offers Bob a 9% loan for 60 months with an easy-to-pay $375 monthly payment. Across the lot, Bob spies the used car section. The salesman’s’ smile slips a bit as Bob begins snooping around in that section. Suddenly, Bob finds a great car that he also likes. It is only 3 years older then brand new, and has a meager 30,000 miles on it. It’s price tag reads $10,000. Poor Bob now faces a dilemma; he can buy the shiny new car with the fresh wax job and that great new-car smell, or he can buy the slightly used car that runs great, looks good, and is much cheaper.

What to do? Most Americans at this point buy the new car. They figure that the cost difference is not that much, and that they can afford the monthly payment, so why not?

In order to help Bob make an informed decision, let’s compare the TOTAL COST of each vehicle. The direct cost for the used car is $10,000. The direct cost for the new car is $28,000 + $4,500 interest = $32,500. Now consider the opportunity cost for the new car. What is Bob sacrificing (besides the dollar cost of the car) in order to have the car? For the used car, he is sacrificing a new paint job, a few thousand miles, and the new-car smell. For the new car, he is giving up the interest he could have earned if he had instead kept his money and invested the $375 that would have been his car payment. If Bob were to invest that $375 each month for 5 years at a 12% interest rate, he would have $30,600 in the bank, $8,100 of which would be earned interest. If he buys the new car, he would have $0 in the bank, and a few scratches on the once-perfect paint. So, the total cost for each car breaks down as follows:

Total Cost = Direct Cost + Opportunity Cost

NEW CAR
Total Cost = $32,500 + $8,100 = $40,600
USED CAR
Total Cost = $10,000 + new car smell = ~$10,000

I’ll let you place your own dollar value on the new-car smell.

Think if Bob were to do this for his whole life. Just pay cash for a car and invest his car payment. If he were to save $375 a month then at the end of 30 years he would have saved $135,000 that would have gone to pay for his cars. If he invested the $375 a month in the stock market and earned the historical stock market average return of 12%, then, after 30 years, Bob would be a millionaire from that alone; his savings account would have a balance $1,310,000. That’s $1,175,000 dollars in interest that the money that would have been paid for cars could instead have earned for Bob’s retirement.

That’s a lot of money to lose out on because of a simple $28,000 price tag on a car. The initial price-tag does not show you the true cost and consequences of your financial decisions. This is why businesses always consider opportunity costs when they are considering what to produce or what services to offer. So the next time you are tempted to purchase anything, think about what the alternatives are. Is there a way you could get far more value for your dollar?

The Word on the Street:

Who doesn’t like to get a big fat check in the mail from Uncle Sam every April?

The Truth:

When one understands a little bit about how the U.S. tax system works, it can be seen that the closer to $0 your tax return is, the better it is for you.

Doubt me? Let’s take a quick look at the tax system and see why this myth is not true.

What is a tax return, and why do I get it?

A tax return is exactly what it sounds like: they are returning your tax money. But wait, why would the government want to give money back? I thought the government just took and took and took some more! Actually, the government did take and take and take. In fact, they took too much money out of your salary over the year, so now they have to return the excess to you.

How do they know how much to take?

The information you fill out in the W4 form at work is used to estimate of how much you should be taxed for the year. This form can be filled out to either reduce your monthly taxes or to increase them. Generally, you want to try to set it up so that you pay the minimum amount of monthly taxes without paying too little taxes. If you pay too little in taxes over the year, then at tax time Uncle Sam comes a-calling and you have to write the IRS a check for the difference. That’s no fun at all. Consult with your accountant for advice on how to fill out your W4 form properly.

So why should you try for a $0 tax return?

The advantage of a $0 tax return rests in a principle called the time value of money (TVM for short). TVM basically means that a dollar today is worth more than a dollar tomorrow. Let me illustrate:

Let’s say you usually get a tax return of $600. If you could reduce that amount to $0, that would mean that you could have an extra $50 a month that comes to you. If you were to invest this money at a safe 5%, then at the end of the year you would have $614. That’s 14 free dollars every year! And if you were to invest at a higher rate (say you put it into a mutual fund) and earn around 12%, then you would have $640 at the end of the year. That may not seem like much, but over the years it adds up, especially with interest working on it. Say you saved that $50 a month in the stock market for 30 years at 12% interest. After 30 years, you would have $176,500. Compare that to the $144,800 you would have if you invested the $600 once a year. That’s a $30,000 difference, and THAT is significant. That is the time value of money; your tax return money is worth more to you if it comes to you sooner in the year, rather than later.

P.S. This is also a quick way to increase your income for your budget!

The Word on the Street:

People often buy homes or other properties because they feel that rent is wasted money. They want to build equity in their homes as soon as possible, and that by paying rent they are “falling behind” in equity.

The Truth:

While it cannot be denied that money paid out in rent is in fact lost and will not yield any future benefit (besides providing shelter), there are reasons to pay rent. In fact, depending on how long you stay in a home, it can actually be MORE wasteful to buy a home.

Doubt me? Let’s take a look at some factors that weigh in on this subject and see what we find.

What is Equity?

One of my biggest grievances against the “rent is waste” argument is that the people who generally espouse and propagate this myth are real estate agents and mortgage brokers. One of their prime arguments is that buying a home builds equity and renting does not.  While this is true, it doesn’t tell the whole story.  There ways to build equity other than buying property. In order to how to build equity, let’s consider what equity is.

Equity:

1. The monetary value of a property or business beyond any amounts owed on it in mortgages, claims, liens, etc.
2. The interest of the owner of common stock in a corporation.
3. The excess of the market value of the securities over any indebtedness.

Websters.com

Simply put, equity is the positive cash value that belongs to you, whether it be contained within the inherent value of a property or whether it be in the stock market, savings account, etc. So you can build positive value and increase your net worth in other ways than in accruing equity in a property.

Disadvantages of home equity

Property equity is an asset much like a fine painting, a vintage automobile, or a rare Mickey Mantle baseball card; IT ONLY HAS MONETARY VALUE IF SOMEONE IS WILLING TO PAY FOR IT!! The only way to access your home equity is to sell the house or take out a home equity loan (which has its own dangers in addition to costing you interest). And when you sell the home, how much equity will you get? You don’t know. An appraiser can estimate the amount of equity that your home has, but until the deal closes and you get a check in your hand, you don’t know how much equity your home truly will give you.

Another problem with home equity is that it is much like any other equity asset; its value can go up or down. While most profitable equity vehicles also have this feature, sometimes it is forgotten that property values can go down. With the 2007 housing slump, this is a point that many Americans have learned the hard way. If the housing market turns sour (or the city build a dump next to your house!), there is not much you can do about your home equity unless you leave your home before the market hits its bottom. Other accounts can be moved or adjusted to try to protect your cash value.

Don’t get me wrong, I think buying a home is a great way to accumulate equity, and it does have some advantages over other equity vehicles. For starters, while it can go down, property value usually increases much more consistently than other accounts. There are always exceptions, of course.

Mortgages Cost

Have you ever looked carefully at a mortgage bill or an amortization table? No? Well, I have an amortization table right here. Let’s take a look and see what we find:

This is for a $200,000 30 year fixed-rate mortgage at a 6% interest rate, analyzed over the first year of the loan. Notice how much is paid in interest. The cumulative interest for the year is almost $12,000!! That’s about $1,000 a month that is lost as surely as rent is lost when it is paid. You only have about $2400 worth of equity in the home, plus any appreciation that the property experienced that year. If you pay a higher interest rate than 6%, then you pay even more in interest and have a higher monthly payment as well.

Compare the mortgage above with the following situation. You rent an apartment for $600/month. You could afford to pay the mortgage payment, but are not sure whether it is a good time to move into a home. Instead, you invest the difference between your $600 rent and the $1200 mortgage payment.

So, after 5 years, where would you stand on the rent vs. buy scenario above? Let’s see.

Mortgage:

• Interest Paid: $58,000
• Equity (no appreciation applied): $14,000
• Total Change in Net Worth: -$44,000 + appreciation on the property

Renting:

• Rent paid: $36,000
• Savings Account Balance (no interest applied): $36,000
• Total Change in Net Worth: $0 + interest on the account

As you can see, the net benefit of renting exceeds the benefit of homeowner ship, at least from a purely mathematical perspective. With renting, you would have received interest on your invested dollars, and with the mortgage, you would have received appreciation on the property.

Many first-time home buyers neglect to account for some of the other costs of homeownership. Things like state property tax and higher utility bills make homeownership just that much more costly without providing any equitable benefit.  Think also about the cost of maintaining the property (not to mention the annoyance of having to fix everything that breaks!).  These costs can be quite substantial, just ask anyone who has owned a home for a significant period of time. When you own your own home, there is no landlord to come fix the broken water lines, or to replace the furnace, etc. Paying to maintain the house does not generally increase the value of the home, unless improvements are made while repairs are going on.

The last word

I know it may sound like I am opposed to mortgages and homeownership. The fact is, homeownership can be one of the best ways to increase your wealth, not to mention the perks of having your own private home. But when considering whether or not to continue renting, don’t just discount renting as an option because it provides no property equity. Take a look at your situation. Crunch some numbers (or find someone who knows how to do it for you), think things through, try to find the hidden costs, and make an informed decision. Homeownership will benefit you greatly in the long run, but in the short term can leave much to be desired.