Question

(Related to the Apply the Concept on page 346 ) The following excerpt is from a letter sent to a financial advice columnist: "My wife and I are trying to decide how to invest a \(\$ 250,000\) windfall. She wants to pay off our \(\$ 114,000\) mortgage, but I'm not eager to do that because we refinanced only nine months ago, paying \(\$ 3,000\) in fees and costs." Briefly discuss what effect the \(\$ 3,000\) refinancing cost should have on this couple's investment decision.

Short answer

The $3,000 refinancing cost should not affect the couple's decision as it is a sunk cost - a cost already incurred and can't be recovered. The investment decision should be based on a comparison between the mortgage interest rate and the potential return rate from other investments.

Step-by-step solution

Understanding the Concept of Sunk Costs

In economics and business decision-making, a sunk cost is a cost that has already been incurred and cannot be recovered. In this scenario, the $3,000 refinancing fee is a sunk cost; it has been paid and cannot be retrieved, regardless of what the couple decides to do with the $250,000 windfall.

Applying the Sunk Cost Concept to the Situation

The refinancing fee should not have an impact on the couple's decision on how to use the $250,000. Letting sunk costs affect decisions can lead to the sunk cost fallacy, where past investments are allowed to dictate future financial decisions, which doesn't lead to efficient outcomes.

Suggestion for Investment Decision

Whether or not to pay off the mortgage should be determined by comparing the mortgage's interest rate with the potential return rate from other investments. If the mortgage interest rate is higher than the expected return rate from other investments, it can be more beneficial to pay off the mortgage. If not, then investing the windfall could be a better option.

Key concepts

Investment Decision

When making an investment decision, it's vital to weigh the potential returns against associated risks and current obligations. In the scenario presented, the couple has a significant windfall of $250,000, and they are considering whether to use this to pay off their existing $114,000 mortgage. Each investment decision involves evaluating alternative opportunities to ensure the most efficient and effective use of funds.

Factors to consider in making this decision include:

• Potential returns from other investments if they choose not to pay the mortgage.
• The terms of their current mortgage, such as interest rates and durations.
• General economic conditions that might affect investment returns, like market trends and interest rates.

Ultimately, making a well-informed investment decision requires balancing these considerations to achieve financial goals.

Refinancing Fee

A refinancing fee is an upfront cost you pay when you take out a new loan to replace an existing one. This new loan generally has different terms, such as a lower interest rate, different duration, or conditions that are more favorable to the borrower's current financial situation.

However, the couple in this situation has already paid $3,000 in refinancing fees. Since these fees have already been incurred, they should not let this payment cloud their judgment on what to do with the $250,000 windfall. Instead, they should focus on current financial needs and future potential gains. Refinancing fees, while influencing initial decisions to refinance, should not factor into future investment choices because they are already spent. This brings us to the concept of sunk cost, which will be expanded upon later.

Mortgage Interest Rate

The mortgage interest rate is a critical factor in deciding whether to pay off a mortgage or invest elsewhere. This rate dictates how much additional money the borrower will pay over the lifecycle of the loan. If a mortgage interest rate is high, it might be financially wise to pay off the loan instead of investing the windfall in potentially lower-yield schemes.

To determine the best course of action, compare the mortgage interest rate with expected returns from other investment opportunities. Here are some steps to follow:

• Calculate the effective interest rate of the mortgage, incorporating any tax benefits.
• Research potential investment opportunities and their expected rates of return.
• Compare the costs and returns to decide which option maximizes financial benefit.

Paying off the mortgage might provide a guaranteed return, equivalent to the interest rate, ensuring funds saved on interest contribute to overall financial health.

Sunk Cost Fallacy

The sunk cost fallacy is a common cognitive error where people continue investing in a situation due to previously invested resources (like time, money, or effort), rather than based on current benefits and prospects. In this context, the $3,000 refinancing fee is a sunk cost. The decision on how to use the $250,000 should not be influenced by this previous expense.

Here's why avoiding the sunk cost fallacy is important:

• Makes sure decisions are based on future potential, not past costs.
• Prevents financial errors by focusing only on current resource allocation and opportunities.
• Allows for a more rational evaluation of present facts and options.

By focusing only on future gains and current parameters, the couple can make a decision that truly aligns with their financial goals, rather than letting past costs lead them astray.