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Chapter 10: Problem 11

(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

Expert verified
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

01

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.
02

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.
03

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.

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Most popular questions from this chapter

(Related to the Apply the Concept on page 346) Baseball writer Rob Neyer described attending a Red Sox game at Fenway Park in Boston and having a seat in the sun on a hot, humid day: "Granted, I could have moved under the overhang and enjoyed today's contest from a nice, cool, shady seat. But when you paid forty-five dollars for a ticket in the fourth row, it's tough to move back to the twenty-fourth [row]." Briefly evaluate Neyer's reasoning.

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