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Opportunity Cost
Opportunity cost is the value of the best alternative you give up when making a choice. In finance, it most commonly refers to the return you forgo by keeping money in a low-yield account instead of investing it.
If you keep $20,000 in a 0.5% savings account when you could invest it at 7%, the opportunity cost after 10 years is roughly $10,000 in foregone returns (FV at 7% = $39,343 vs. FV at 0.5% = $21,023).
Opportunity cost is central to rent vs. buy analysis: the down payment you put into a home could instead be invested, generating returns. Understanding this cost is why rent-vs-buy comparisons should always include investment return on the down payment.
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- Time Value of Money (TVM)
- The time value of money is the principle that a dollar today is worth more than a dollar in the future because money available now can be invested to earn a return.
- Rate of Return
- A rate of return (RoR) is the net gain or loss of an investment over a specified period, expressed as a percentage of the initial investment.
- Compound Interest
- Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods. It causes savings and investments to grow exponentially over time.
Frequently asked questions
What is Opportunity Cost?
Opportunity cost is the value of the best alternative you give up when making a choice. In finance, it most commonly refers to the return you forgo by keeping money in a low-yield account instead of investing it.