There is some debate as to whether opportunity costs can in fact be negative. The argument goes that opportunity costs are the profit foregone from choosing the next best alternative. The key concept in this argument is “the profit foregone” not the cost foregone. But this approach fails to consider the possibility that an investor could easily be faced with the choice between making an investment or paying down a loan. When a liability or debt is involved, then the choice changes from “what is the lost opportunity of not making a particular choice” to “what is the potential realized loss from not taking a certain action?”
Perhaps an example will help. Let’s say you have $10,000 to invest and are able to purchase a fixed income investment that will pay you 5% annually, giving you $500 per year. At the same time, let’s say you have a mortgage on your house that is costing you 7% annually. If you use the $10,000 to help pay down the mortgage instead of investing it, you are saving 7% in interest expense, or $700. In other words, by paying down the principal on the mortgage by $10,000, you won’t have to pay 7% on this borrowed money, saving yourself $700 a year, which is the same thing as earning $700.
So here you are faced with an opportunity cost that could potentially be negative. How? Because the 7% rate of borrowing is higher than the 5% investment return, if you chose to make the investment instead of paying down the loan you will have a negative opportunity cost at the end of the year. $10,000 at 7% is $700 in interest expenses on the mortgage, while $10,000 at 5% is $500 in income from the investment. By not using the money to pay down the mortgage, the opportunity cost is $200 in net interest expense. This is a negative opportunity cost. It is $200 out of your pocket as a cost, rather than a foregone profit.
Using our earlier calculation for opportunity cost you get:
Opportunity cost of not paying down the mortgage: ($700) / $500 = ($1.40) per year
In words, for every dollar you earn from the investment, you sacrifice the opportunity to reduce debt by $1.40 over the course of a year. The cost is negative for two reasons. First, every dollar of investment is insufficient to cover the interest you are paying by $0.40. Second, every dollar of return on your investment is offsetting the interest expense as well.
In our example above if the investment had a return of 5% and the loan had an interest rate of 5% then the opportunity cost would be zero. The return would offset the interest expense and the investor would be no better or worse off from making one decision over another.
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