What is Opportunity Cost and why it matters in Real Estate Investing
This is the opportunity to talk about how to manage your budget efficiently. When you work with Real Estate, one of the most important things you have to know very well is how to manage your personal incomes.
For this, you have to take into consideration what opportunity cost means. This economic concept is related to your budget and your personal income management.
If you want to become a Real Estate Investor, you have to manage your finances and your money very carefully. When you start in the real estate business world, you have to be smart, not only with your expenses, but also the payment methods you normally use.
What exactly does opportunity cost mean? This is a concept that basically means the cost of achieving something and giving up something else.
Opportunity Cost and Real Estate
For example, you have exactly $100. Forget about credit cards, forget about any savings, you have exactly $100. Then with that $100, you have two choices:
- One is to eat and get your groceries for the week or for the month
- The other is to use these $100 to get a jacket, a coat.
You are going to have to decide which of the two you’re going to want to purchase with that $100. It cannot be both. You could split it, but you’re going to end up paying for something else.
If you decide to split this in half and half. That means you are going to have to give up some food. You’re still giving up something, or maybe you’re going to have to buy something that is cheaper or maybe less quality. Maybe instead of eating steak, you wind up eating chicken, or maybe having to have a vegetarian meal because it’s cheaper that way.
You’re going to either have to wait another month to save another $50 maybe, to get that jacket, or you’re going to have to wait for it to get on sale. Even if you wait for it to go on sale, you’re still giving up something and that is your time. Meaning you’re not going to be able to buy it today. The goal is making a decision with this $100 so you can get something today.
You’re giving up quantity, quality and time. That’s in essence the meaning of opportunity cost. What can you get with that money? What can you get with something that’s going to help you get to the other end of what you’re trying to get?
Opportunity cost: Big decisions
Once you become a real estate investor and you have access to funding, you have big, big decisions to make. For example, new people in the business have access to funding. If you have a property that you have available and you manage to get out a cash-out refi.
If you don’t know what a cash-out refi is, you can check this link.
You always have to analyze: “What can I get now with less money, and that benefits me the most at the same time?”
If you get an additional credit, like a cash-out refi and you’re not using it to create additional income, that means is going to be an added stress for you and something else that you’re going to have to worry about repaying while you’re still trying to find the new investment for that particular budget that you have.
It is not only about knowing what your expenses and personal income are, you must calculate them
Imagine that you were able to get enough money to apply for a mortgage and you got for the $30.000 from a Cash-out Refi for the down payment. You want to use $10.000 for the first down payment of your new mortgage and other $10.000 to renovate the floor of that house.
In these cases, you have to be aware of the opportunity cost. You have to use the money you have available for the real important things, like paying the 20% of the mortgage you’re applying for. Making renovations on that new property will not give you any incomes back right away and it will be difficult to recover that investment.
So, what do you prefer? Sacrificing the new floor or the whole investment? Securing a source of income and waiting for that new floor is the best choice.
You’d rather use that $30,000 that you got out of your cash-out refi because now instead of buying a single-family home, you can purchase a duplex or maybe you can buy two family-homes instead with the money that I get out of the cash-out refi.
Now you have two properties that are income-producing and they’re repaying the mortgage back and at the same time, maybe you wind up with something extra that’s going to help you use that money and do the repair and that floor, or like nicely fix that floor the way you exactly want it to be.
¿What about Utilities?
Opportunity cost is one of the major exercises that we actually teach in our mentorship program at Novarise Invest. Think of everything you spend on a monthly basis. Utilities are bills that you have to pay. Some of them are:
- Telephone bill
- Internet bill
- Electricity bill
Those things that you will need in order to live comfortably. Then maybe about this much will be for your rent or if you have a mortgage, then it’s typically a little bit higher, because you have to pay for insurance, you have to pay for property taxes.
This can be named as mortgage expenses. Then everything else that you wind up in this section it’s either going to be savings or maybe your disposable income. Meaning anything that you spend for recreational purposes.
Like hanging out with friends, going out with friends for dinner, or maybe going to the movies, or maybe hosting a party in celebration of something.
Shift your spending habits: A good way to shift your spending habits is instead of hosting in your house every single time gathering for your friends, maybe this time what you can do is to do what they call a potluck.
You bring some snacks and then another friend will bring a lasagna, another friend will bring the drinks, whatever is it that your environment typically drinks in a gathering or, then another friend ends up bringing the ice or the cups and stuff like that.
Having control over your personal income is essential to being a financially successful person
That way, everyone is chipping in, everyone is contributing towards the gathering, the enjoyment, because at the end what really matters is having that connection with the people that you’re close with, but you don’t necessarily have to expend an extra budget going all the way out to the next level, just so that gathering can happen.
Instead of going to a restaurant and paying $30 to $60 per person in a dinner because they can’t add up to that, you take those $60 and then, again, do the same thing, do the whole potluck concept.
That’s only a temporary shift that’s going to allow you to use part of that money on the discretionary section all the way down into the savings, so instead of waiting 10 years before you can save the amount of money that you need for the downpayment of your property, you can cut down those 10 years to 2 years.
About the rent: there’s not much you can do about it because as long as you have a peace of mind in your own home then that’s a different story. You need to feel comfortable, you need to maintain your sanity in order to keep pursuing your dreams, you need to rest and kind of like gather yourself together so you can keep pushing forward.
In terms of opportunity cost is making a sacrifice now and in two or five years wind up paying back because you did things right correctly the first time and now that passive income is starting to happen.
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