Planning Long Term Purchases

Planning Long-Term Purchases

When evaluating how to spend your money, most people make a fairly simple comparison. If the benefit they believe they will receive from the purchase is greater than the cost, then most people go ahead with the purchase.

To master your personal finances, you need to start thinking long-term. There are many potential purchases you believe are worth the money, so you spend money now instead of saving for the future. In order to change your mindset, you need to start thinking long-term. By building a toolkit that helps you consider how a purchase will affect you in the future, you’ll start to make smarter financial decisions.

Opportunity Cost and Depreciation

When you start planning ahead before making a purchase, you no longer focus solely on whether it’s worth the money. You’ll begin to think about how this purchase will impact you moving forward. To make this process easier, start by applying some economic and financial concepts to your purchases.

Opportunity cost and depreciation are two important financial concepts that can have a significant impact on how you approach your personal finances. Understanding how purchases will impact you in the future will help you make more informed financial decisions.

Opportunity Cost

The opportunity cost of a purchase shows you what you must give up when you buy something. For example, if you purchase a new smartphone for $1,000, the cost to consider isn’t just what you spent on the phone, but other things you could have done with that money instead. This includes purchasing other products, saving the money, or investing it and gaining interest on your investments over time.  

When you make an expensive purchase, keep in mind that this money will be unavailable for other wants and needs. Would you be willing to take $1,000 out of your investments to buy the smartphone?

What if you bought a two-year old model instead of buying the latest version?

If you found someone offering to sell you a secondhand version for $600 instead of spending $1000 on a new one, you would be saving $400. You could then invest that $400 in your savings or put it towards another investment. This way, you are maximizing the value of your purchase and making a more financially responsible decision.

Amortization and Depreciation

Amortization is a financial term that refers to spreading out the cost of a purchase over the useful life of the item instead of paying for it all at once. This means you can enjoy the benefits of the item over time, rather than paying for it upfront and then not having any funds left over. For example, if you buy a $1,000 phone and plan to use it for three years, you could view the cost as $266.67 per year.

Depreciation describes the fact that most items lose value over time. The new smartphone you purchased will eventually get slower and will become less reliable. The novelty you got when you first purchased it will wear off the instant a newer model is released. However, that item still has value. Your smartphone may only be worth $600 in two years, but it still has value.

Higher-quality items are generally known to depreciate at a slower rate than their lower-quality counterparts. This means that investing in a more expensive item may actually be more cost-effective over time, since you’ll receive more value out of it over a longer period.

Combining Concepts

When you plan for a purchase, you should consider a combination of the value of the item; the monetary cost, your opportunity cost, and the depreciation rate of the purchase. The more expensive the item is and the longer you think it will last, the more important this balance becomes. 

You’ve learned to look beyond the simple idea of whether or not you can afford it. Now, you can see how your purchases have long-term consequences on your future quality of life.

Keeping with the smartphone example, let’s assume you’re still deciding between the newest model at $1,000, and a two-year-old model priced at $600. To make a decision, you need the following information:

• On average, people keep their smartphones between two to three years. Let’s assume, you’ll keep yours for three years.
• You also need something to compare the purchase against. The S&P 500 stock index has an average long-term rate of return of 11%. We won’t be too optimistic, so let’s assume you’ll be able to invest in the S&P 500 Index Fund (SPY ETF) and receive a return of 8% per year.

Step 1: Calculate Realized Purchase Cost

Your realized purchase cost will be the sticker value, plus the opportunity cost. In this case, if you bought the new phone, it would cost $1,000, (assuming all fees and taxes are included). If you bought the older phone, it would cost $600, and you could invest the money you saved at a rate of 8% for three years.

Using the compound interest calculator, you can see that the $400 you invested would grow to $504. An extra $104! Since this is cash you wouldn’t have gained otherwise, you can subtract it from the purchase price of the secondhand phone.

Now, you’re comparing a $1,000 new phone with a $496 older phone.

Step 2: Amortize the Cost

Next, you can amortize the cost over the phone’s useful life.

• New $1,000 phone costs $333.33/year for three years.
• Old $496 phone costs $165.33/year for three years.

You can see that the older phone is still much cheaper per year. However, that isn’t surprising since the older phone is less valuable than the new one. This exercise isn’t just about analyzing the trade-offs at the time of purchase. The purpose of amortizing the cost is to have a number that you can depreciate, so you know what this phone is costing you per year that you own it or intend to use it.

Step 3: Depreciate the Value

Next, you need to figure out how quickly the value of your phone will disappear. If you use market data to assess the decay rate of your smartphone, you can see that the $1,000 phone will decay to $600, (a $400 decrease) within three years, 60% within two years, or 30% per year.

At this point, you need to specify how much you personally value each phone you’re considering.

It could be that the new phone has some amazing new feature that you would be willing to pay $3,000 for, and the $1,000 asking price is a steal. Or it could be that you value the phone just a little bit more than the asking price. When you depreciate the value of a phone, you are not depreciating the money it costs you to buy it. You are depreciating the value you place on owning it.

At this point, you still don’t know how much you value these phones (either by themselves or relative to each other). So, let’s assume that you value the phones at least as much as they cost. Then, you’ll need to take the amortized value and depreciate that to get a minimum amount you must value these phones to even consider buying them.

These totals are less than the price, so now you can find the break-even value for each phone.

The break–even point is when the cost of the phone is equal to how much you value it, including how much value it loses over time. Regardless of the alternatives, you would not buy a phone for a higher cost than you value it.

New phone: $1,000.00 – $699.98 = $300.02

This means you need to factor in $300.02 in lost value over the life of the phone by adding it back in to the purchase price.

$1,000 + $300.02 = $1,300.02 break-even point

For you to consider purchasing the new smartphone, you need to value it at $1,300.02 or more. (Notice we are not even comparing the new and old phones.)  This is the minimum value you need to put on this phone for it to be an option. If you cannot say that you would get $1,300.02 of value out of the new phone, our decision is over.  Do not buy it.

Old phone: $496.00 – $346.39 = $149.61

 This means you need to factor $149.61 in lost value over the life of the phone by adding this back into our purchase price.

$496 + $149.61 = $645.61 break-even point.

For you to consider purchasing the old smartphone, you need to value it at $645.61 or more. (Again, we are not even comparing with the new phone.) This is the minimum value you would put on this phone for it to be an option. If you cannot say that you would get at least $645.61 in value out of the old phone, your decision is over.  Do not buy it. 

Step 4: Make a Decision

What we calculated in Step 3 was the minimum values for how much you value each phone. Now, you can calculate the difference in these values:

$1300.02 – $645.61 = $654.41

You have all the information you need to make your decision of which phone you want to buy. Do you think you’ll get $654.41 more in value from the new phone than from the old phone?

This is completely up to you. Nobody can tell you how much you personally value either phone. The purpose of this 4-step process is not to tell you which choice is best. It’s for you to see the full impact of your decision across time.

Once you factor in opportunity cost, amortization, and depreciation, the choice of phone looks a lot different. A $400 sticker price difference transforms into a $654.41 value difference once you look at how the purchase impacts you across time. This means a smart shopper will go for the older phone, unless they can justify to themselves why the new phone is worth $654.41 more.

Hold On, This Is Way Too Complicated!

Now that you have seen all four steps in action, you can understand the value of looking at a purchase over a longer period of time. However, it’s unlikely you’ll make all these complicated calculations while standing in a store considering two alternatives you want to buy.

And you are completely right!

It will be very rare when you compare two or more options using this full process. At most, you might sit down for the full calculation once or twice per year. The important thing is not that you calculate the exact realized purchase cost, amortized cost, and depreciated value, but that you remember all three of these factors should weigh into your purchase decision, not just the sticker value.

Calculate at the Check-Out

When you’re making a purchase for a long-term use item, take a moment to consider how long you expect it to last. Keep in mind that the money you’re spending on this purchase is money you won’t be able to use for other things such as investing. Therefore, you may want to add a bit of extra cost to account for the opportunity cost of not using the money for other investments.

Now divide that full cost over its useful life, whether it’s six months or five years.

Every purchase you make has a useful lifespan. It’s important not to assume that a purchase will last forever. Whether it’s due to wear and tear, new and improved options becoming available, or changes in your own needs, it’s likely that you’ll eventually need to replace the item. To help keep things in perspective, consider the maximum useful life of the item before making a purchase. This will give you an idea of how much the item will cost per week, month, or year of its life, and help you make a more informed decision about whether it’s worth the investment.

Finally, consider how fast the purchase will lose its value. A lot of technology loses its value fast. Our cell phone example was decaying at about 30% per year. Better alternatives are always coming out and new apps are released that require newer hardware. Your clothes will also have a fast decay rate since they go out of fashion or are damaged through normal use. Other purchases, like kitchenware or furniture, will lose value more slowly.

You do not need to take out your calculator and get exact numbers for each step, but you do need to remember that all of these factors exist! Just keeping that in the back of your mind will make you a much smarter shopper and will help you see the true value and cost of your long-term purchases.

Challenge Questions

1. Using examples from your own life, explain what opportunity cost is.
2. Why should depreciation be a consideration when purchasing a product?
3. In the text above, what is meant by the real cost?
4. Explain what you understand by the term amortization and how would you explain it to someone else using an example?

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