If you pay 12% to borrow & receive 6% interest on your own funds, do the opportunity costs of borrowing & using your own funds differ? Why?Lenders perceive that you are risky, so you must...

If you pay 12% to borrow & receive 6% interest on your own funds, do the opportunity costs of borrowing & using your own funds differ? Why?

Lenders perceive that you are risky, so you must pay 12 percent annual interest to borrow from one of them. You only receive 6 percent on funds you have deposited in the bank. Do the opportunity costs of borrowing and using your own funds differ in this example? Explain why or why not.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

Yes, the opportunity costs of these two options differ.

Let's say, for the sake of having easy numbers, that you want to use $10,000 and you have the choice between borrowing it and using your own savings.  If you borrow, you will incur interest of about $1200 in the first year.  Thus, your opportunity cost for borrowing would be whatever you would have done with that $1200 had you not been required to pay it off in interest.  If you use your own money instead of keeping it in the bank at 6%, you are giving up $600 of interest in that year.  Your opportunity cost is whatever you would have done with that $600 if you had received it.

In this way, the opportunity cost of using your own money does exist, but it is only half the opportunity cost of borrowing.

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