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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Related terms
- 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.