If you won the lottery tomorrow night, would you clear all your debts all at once? Conventional wisdom would dictate that being debt-free is best, but what’s the cost of being debt-free? Mentally, there is freedom, but otherwise, is it the best use of your newfound wealth? These questions come back to a little economic concept known as the opportunity cost which discusses the ‘cost’ of choosing one option and foregoing the other.

Now, several readers here run for the hills whenever they see finance, economics or maths, so let’s give a simple example to keep it real for everyone. When you were younger, your parents would probably say you only choose one out of two video games today or wait a couple months to buy them when there is more money, or the games became cheaper.

Now, some of your classmates might be talking about the experience of both games when you go back to school after the holidays. Being part of those discussions and having a semblance of belonging can be quite a hard thing to ignore as a kid, but on the other hand, you equally like both games and want to enjoy both of them. For some people, they would choose the option of getting one game today to be part of that social grouping and enjoy the thrill of playing that game while others would bide their time because they’d have both games and be able to enjoy them as they please.

In one scenario, getting one game brings an immediate social benefit while waiting in the other scenario carried less social benefit but a greater reward. This is an oversimplified version of what opportunity cost really is. It’s the cost of making one choice over another, sometimes having a serious financial implication.

Let’s get back to that lottery discussion now. If you had a car loan and mortgage which each had interest rates below 10 per cent, then paying off these loans might not be the best financial option off the bat. If you can find investments like stocks, bonds, mutual funds/unit trusts or alternative investments that can give you 12-15 per cent yields annually, then it might be better to invest those sums than to pay off the debt all at once. You’d have less cash to invest if you paid off the debt all at once, and if you remain current with your obligations, you’d still be a valuable customer to that lending institution.

Now, let’s tilt the scales a bit and have a different scenario where someone has probably two or three maxed out credit cards, some loans from different microcredit firms and is barely getting by daily. In that scenario, paying down the debt works out as a great option since credit cards usually carry annualised interest rates above 50 per cent in Jamaica, most microcredit firms will charge annualised interest rates probably two to four times what a bank would offer, and the quality of life is not in the best state at all. There would be no low-risk investment that would provide returns that high to compensate for the compounding effects of credit cards or the rates charged by microcredit firms.

Even the lottery prize is an opportunity cost that each winner has to judge in their own best interest. Lotteries usually offer the winner two options for their payout, a lump sum payment or an annuity. Most lotteries will have a face value of let’s say $500 million, but if you take the lump sum payment which is immediate, you’ll probably get $200-$250 million after accounting for taxes. The annuity is a structured payment over say 20 years where you’d receive probably $300-$350 million in total. While the annuity guarantees a larger nominal payment and ensures that some lottery winners will better manage their money, the opportunity cost by waiting would be tremendous. When you get that large upfront payment, you can invest that into other assets which can potentially be worth $1 billion or more over that same 20-year time span. So, taking the lump sum payment is usually the better option in most cases as a dollar today is worth more than a dollar tomorrow.

Businesses generally compare the return of different projects and value the prospective opportunities that come with choosing one investment over another. Some costs aren’t readily quantifiable in the near term due to the availability of information, but the future opportunities from making the best decision can be quite significant.

While most people don’t usually quantify opportunity cost, most people do use some level of general reasoning to determine what’s the best option for them to take in their daily lives. One way in which people apply opportunity cost is through delayed gratification where they determine that certain immediate decisions will sacrifice future opportunities where they can be much better off. For some people, this might be choosing to buy a regular car over a brand name German vehicle until they’re earning more to afford their dream car. For others, it might be to rent in the interim while they accumulate enough funds to get their desired house. One thing we should always remember is that cash and time are finite resources which means that any action we take should consider the potential risks and rewards from that decision.