Opportunity Costs in investing

What is the cost of our investment choices?

Source

In my last article on the movement of money I discuss the opportunity cost of one choice over another when paying bills. In this article I would like to discus the use of cash versus the use of leverage, in terms of opportunity cost.

One of the important concepts that I learned from studying bank lending practices is fractional lending. In the illustration of this type of lending we saw how each time the bank loaned people money, people deposited it in an account where they left it to pay bills as they occurred. But the bank withdrew that money time and time again to reinvest it in an additional loan. Now the bank takes that money and invests fractions of it in multiple enterprises and creates 10 streams of income from that cash deposit. Now while people are not banks, so we can’t do Fractional lending like banks, but we can do Fractional investing using fractions of our money plus other people’s money and this is called leverage.

Banks can do Fractional lending, thus allows them to loan out money multiple times, so their $1000 dollar loan generating 10% interest becomes 9 smaller loans all generating streams of loan repayment income. People can take the same 1000 dollars and instead of investing in one income generating asset, then can divide it into fractions like tenths, then buy ten different assets by putting ten percent down and borrowing 90% from other people. As you can see the banks have access to lots of stagnant money which is sitting in savings accounts or certificates of deposit earning 1% interest. This is the source of loans the banks give to people like you. I call this Fractional investing, other people call it using leverage.

Example;
If you have $100,000 to invest and you purchase an apartment unit, which you then rented for $900.
Now you have no loan on that property, so you have $900 of positive cash flow per month. But there is an opportunity cost in having your entire investment capitol tied up in this one investment. Because you can’t invest in anything else. Alternatively you could do Fractional investing or use leverage to purchase not just that unit but ten units total.

Example:
If you took that same $100,000 and you invested it in 10 units putting down $10,000 apiece and borrowing money from the bank $90,000 for each unit.
If your rent is $900 and your loan payment is $800, your positive cash flow is $100 per month, per unit, so 10 properties would generate a total of $1000 of income per month as opposed to the $900 that you were generating with the single unit. Now you might say I’ve only gained $100 by purchasing 10 more unit. You are half correct because the rent isn’t the only way I Profit. Remember assets appreciate in value, so over time these units will appreciate or increase in value.

So if you look at the same scenario, if you’ve paid hundred thousand dollars for one and that unit appreciates 20% and you now have a $20,000 profit on your hundred thousand dollar investment.
But if you had purchased 10 units of equal value and each appreciated $20,000 you would have a net appreciation of 10×20 or $200,000 versus your net appreciation of $20,000 for the purchase of one units. This difference of $180,000 is the opportunity cost of paying cash for one unit. We would have lost the opportunity to buy ten units because of that decision.

So in this example the most common reason people give for not using leverage to buy more then one unit is because of fear of debt. In my opinion this lost opportunity occurs when people fail to distinguish between good debt and bad debt. We are all raised to think that being in debt is bad. But like most situations in life its not as simple as that, and in reality there is both good and bad debt. The good debt is that which we create to own assets, which are appreciating in value and creating income we can use to pay the loans or debts we used to acquire them. The bad debt, is that which we create to purchase liabilities, items which are depreciating in value and which don’t generate income.

Remember knowledge is power, which can be used to generate wealth, which is freedom.

In our next article we discuss savings vehicles with compound interest, which allow us to save and borrow at the same time. See you there.

✍🏼 Written by Shortsegments.