Economists stress the notion of “opportunity cost,” which says that the true cost of a decision isn’t the amount of money flowing out of one’s possession, but rather the value the chooser places on the second-best option that is now impossible because of the original decision. This concept of opportunity cost features heavily in the “infinite banking” community, meaning the financial professionals and policyholders who use Whole Life insurance for cash management, in the tradition established by the late R. Nelson Nash.
In the present article I’ll first elaborate on what economists mean by “opportunity cost,” and then I’ll show its application to life insurance. Finally, I’ll give a warning on pitfalls to avoid when applying opportunity cost to the realm of personal finance.
The best example from my personal life of opportunity cost is a story from when I was a grad student at New York University. The United Auto Workers (UAW) came in and were trying to unionize the grad students. The NYU administration did not want this to occur, and so ahead of the vote, they were doing damage control. The provost (I believe) came to talk to the students in the economics PhD program. (Full disclosure, I wasn’t personally at this meeting, but another student later told me that this is what happened.)
The provost asked why the NYU students were so unhappy, and what could the administration do so they wouldn’t feel the need to vote to bring in the UAW. One of my classmates—who was very good at math and thus did well in the model-based doctoral program—said, “Besides the stipend, we want to be given subsidized housing, just like the students at Columbia University get.”
The provost replied, “Sure, that’s fine, but here’s how we’re thinking of it: Right now, as a doctoral student, we give you a pile of money each month in exchange for your duties as Research and Teaching Assistants. So you can spend that money on rent or food or whatever you like. If you want, we can certainly give you below-market rental rates for NYU housing, but that of course means we would have to reduce the amount of cash we give you each month. Is that what you want us to do?”
The student—again, who was getting a Ph.D. in economics from what was a top-15 in the world program—pushed back, saying that because NYU owned the actual apartment buildings in the neighborhood, it wouldn’t cost NYU anything to give subsidized rent to the grad students.
This was a jaw-dropping fallacy. The student was ignoring the opportunity cost of NYU renting out an apartment unit at below-market rates. If, for example, an apartment in Greenwich Village would have normally gone for $2,000/month, but NYU rented it to a grad student for $1,500/month, then in a very real sense that decision would “cost” NYU $500 per month. This is true, even though money wouldn’t be flowing out of NYU’s checking account.
As I said in the introduction, Nelson Nash used these ideas throughout his writings and public talks when it came to the use of Whole Life insurance for cash management (what he called Infinite Banking). Specifically, Nelson famously stated that you finance every purchase you make, whether you “pay cash” or borrow to do so.
Here’s what Nelson meant: Suppose you want to buy an appliance, but you don’t have any spare cash at the moment. So you borrow (say) $1,000 to make the purchase today, promising to pay back $1,080 a year from now. (This isn’t how normal financing programs work, but I’m trying to keep the math simple.) So most people would look at this case and say that the appliance costs $1,000 today, but your decision to borrow the money added $80 in finance charges or interest expense. They might even say that if you finance the appliance purchase, it “costs $80 more” than if you “paid cash.” Some might even link this extra cost to your impatience, saying that if you had simply waited a year—until the point at which you had the money—then you could’ve bought the appliance at that point, and saved yourself $80 in finance charges.
But as Nelson points out, this perspective is missing something important. Even if you started with $1,000 in your checking account at the beginning, and “paid cash” for the appliance, it is still the case that your decision to buy now, rather than waiting a year, has “cost” you $80. Assuming that the going rate of interest is 8%, if you had first lent out or invested your $1,000 in instruments that yielded 8%, then after a year had passed, you would have $1,080 in your possession. At that point, you could “pay cash” for the appliance, and then you’d have the appliance plus $80 left in your checking account.
And so we see that your impatience or unwillingness to defer consumption “cost” you $80, whether you “paid cash” upfront or borrowed money from outsiders. And just like in the NYU apartment example, we here mean “cost” in the sense of opportunity cost, of comparing the outcome of your decision, with an alternate timeline in which you had made the next-best decision.
In the context of using Whole Life insurance for cash management, Nelson’s principle dovetails with what he called “playing honest banker with yourself.” For example, if you run a business and want to use funds to buy a new piece of equipment, the true “cost of capital” isn’t necessarily what the life insurance company charges as a policy loan interest rate. (For more details on how Whole Life and policy loans work, see my previous article.) If some other business would be willing to pay, say, 8% to borrow capital from you, and you thought the likelihood of default was no worse than how the money would be used in your own business, then that 8% is the relevant figure. The fact that the life insurance carrier might lend to you at, say, 5% wouldn’t be decisive. If you wanted to use those funds in your own business, Nelson would advise that you “pay yourself back” (from the business into your Whole Life system) at least at the 8%, because that is the true “cost of capital” in this scenario I’ve sketched.
Now that I’ve shown how opportunity cost can be applied to personal finance, let me give two warnings so that you can guard against ways I’ve often seen people misinterpret this framework.
If you spend $100 today buying dinner at a fancy restaurant, the cost is $100, measured in today’s dollars. It would be misleading and confusing to say, “When you factor in the lost opportunity cost, that steak dinner really cost you $2,000.” If you want to make such a point, it would be more accurate to say, “The steak dinner cost you $100 in today’s dollars, or it cost you what could have been $2,000 available at your retirement.”
The essential insight here is that $100 today is not the same thing economically as $100 that won’t be available until decades in the future. This is why interest rates are positive; think of them as the “exchange rate” of present dollars for future dollars. If the interest rate is 8%, that’s just shorthand for saying that $1,000 in 2024 dollars trades in the currency markets for $1,080 in 2025 dollars.
So to return to our personal thinking of buying an appliance, we established in the previous section that—contrary to popular opinion—it’s not the case that paying cash is “cheaper” than financing. If you have no money right now, but will have money in a year, and you go ahead and (through financing) buy the appliance today at an 8% APR, then next year you have to pay back the $1,000 in principal and the $80 in finance charges. If you had instead waited a year to pay cash, you would only have to pay (at that time) $1,000. This is why people think financing “costs more,” and in this case, they’d say it added $80 in expense.
But again, as Nelson showed, this isn’t the right way to think about it. Even if you had the $1,000 at the outset, if you had been willing to wait a year, then you could have had $1,080, at which point buying the appliance would put you $80 ahead of where your alternate-timeline self would be, had you paid cash at the start. So either way, the decision to get the appliance a year early “cost” you $80 as measured at the second year.
Yet stepping back from all of this, it is still perfectly correct and acceptable to say, when someone buys the appliance in the beginning, “This cost $1,000.” The reason is that you are referring to dollars right now. So the insight Nelson is offering is that whether you pay cash or finance at 8%, the cost of the appliance right now is $1,000. If instead you want to say, “Oh, but a year from now, I’ll have to pay an extra $80 if I finance it,” then to be consistent you should say, “Oh, but a year from now, the guy who ‘paid cash’ today for the appliance is now $80 poorer than he otherwise would have been.”
I realize this stuff can be confusing, so let me state the situation this way: We can express measurements in different units. For example, I could say, “The length of that piece of string is 1 meter or 100 centimeters.” Likewise, I can say the price of our hypothetical appliance is 1,000 2024 dollars or 1,080 2025 dollars. Dollars-in-2024 are a different unit of measurement than dollars-in-2025. So again, the way to use Nelson’s insight is to realize that the price of the appliance is the same, whether or not you finance it or “pay cash.” Nelson has not shown us that if you spend $1,000 today, you “really” spent an infinite amount of money…
Another common pitfall in this arena is to ignore the policy loan interest. So for example, someone might argue, “If you pay cash for that appliance, then the money is gone and you’ve forever lost the ability to earn interest from it. In contrast, if you keep your capital in a Whole Life policy and finance the purchase via a policy loan, then your money continues to grow.”
Strictly speaking, these statements aren’t wrong, but they can be misleading. Specifically, they are downplaying the fact that if you “pay cash,” you don’t have a growing lien against your assets, whereas if you finance with a policy loan, then you do have an exponentially growing liability that offsets (perhaps more than offsets) the retained growth in your policy.
For those interested in seeing this issue spelled out, I devoted two previous articles (here and here) to the topic.
NOTE: This article was released 24 hours earlier on the Infinite Banking (IB) 3.0 - The Future of Finance Facebook Group
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
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