04 May What is ‘opportunity cost?’
Q. What does “opportunity cost” mean? I’ve seen you use the phrase in stories about 401(k) loans.
A. We love questions like yours. If you see something you don’t understand in our stories — we try to be jargon-free — yes, yes, yes! Please ask.
Opportunity cost refers to the loss of potential gain by choosing one alternative over another, said Joseph Sarnecki, a certified financial planner with U.S. Financial Services in Fairfield.
“Opportunity cost presents itself in many aspects of life, especially economics,” he said. “In investing, opportunity cost is the difference in overall return between a chosen decision/investment and one that is passed on.”
A common example of this is when people who are afraid of risk say, “I am going to keep my money in the bank, where I know I cannot lose it.”
While keeping their money in the bank is a “safe” investment, we all know that banks are paying practically nothing in interest, Sarnecki said.
Indeed: According to Bankrate.com, the national average for a savings account is less than .10 percent.
The opportunity cost in this situation is the difference in potential gain over time had the individual invested these funds into something else, such as the stock market or real estate, he said.
Regarding opportunity cost in 401(k) loans, let’s first revisit how a 401(k) loan works.
Sarnecki said a 401(k) plan will typically let you borrow 50 percent of your vested account balance, up to a maximum of $50,000. Not all plans allow for this provision, so it is important to check with your plan administrator if a loan is allowable.
He said once you decide to take a 401(k) loan, you will choose a loan repayment schedule, up to a maximum of 60 months, unless the funds are used for a primary residence purchase. The loan is paid back through a participant’s paycheck, with interest, where the interest is credited back to the participant’s account, in essence, “paying yourself the interest.” As long as payments are made on time, the loan is penalty and income tax-free.
But as with most investment decisions, there is an opportunity cost when taking a loan from your 401(k) plan.
“When you take a loan, the funds you are `borrowing’ are actually removed from your account until you repay the loan,” he said. “As the funds are removed, they are no longer invested in the plan, potentially growing tax-deferred.”
Sarnecki said the opportunity cost of the plan loan is the amount those funds could have earned had they still been invested in the plan. And, in some circumstances, the opportunity cost is greater as one may not be financially able to continue to contribute to their plan and payback the loan, so they miss future earnings on those contributions in addition to a company match, if available.
There’s also the risk of having to pay the loan back if you leave or lose your job.
Sarnecki said he recommends speaking with a financial advisor to understand the full impact that taking a 401(k) loan may have on your financial situation.
“With that being said, if you do need to take a loan, it is typically recommended to take the minimal amount needed and try to pay this back in the shortest amount of time possible,” he said. “Try to keep your contributions the same as they were prior to taking the loan, and finally, if you happen to have the magic crystal ball everybody is looking for, take the loan prior to a market decline — I am of course joking, as it is not possible to truly time the markets.”
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This story was first published in May 2017.NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.