What is price?
This may seem like a silly question, but it is, in fact, important to understand what price is and what it isn’t. Price is the dollar amount stated on the sticker. For example, when you buy airfare from a discount airline, the price of your ticket to fly from NY to LA might be $299. $299 may well be the price, but anyone who has had the pleasure of flying on a discount airline knows full well that won’t be the full out-of-pocket cost.
What is cost?
Cost is the total cumulative amount you will have to pay to purchase, utilize, and maintain whatever it is you’re buying. Sometimes the amount above and beyond the price is obvious and easy to determine, and sometimes it’s not.
Let’s go back to the airfare example. What the $299 price of the airfare doesn’t include are many other fees that will be required for you to actually use that ticket. Want to choose your seat? That’s an extra $25. Do you and your travel companion want to be able to sit together? Tack on another $30. Are you traveling with literally anything other than your physical self? You’ll be charged $20 for a personal item and then another $35 for each additional carry-on item…you get the picture. In the end, the price of your $299 ticket might pale in comparison to the total cost you pay to actually use that airfare.
A simple example
We make these price vs. cost decisions more often than we might realize, especially for smaller items. Say you’re looking to buy a new garden hose on Amazon. You may be looking at two options, both of which have plenty of reviews. One hose has a 3-star rating. The comments state that it works well, but that you’ll probably have to buy a new nozzle after a year since it’s made with cheaper material. This hose has a price of $30. Out of curiosity, you do some research and find that replacement nozzles run about $10.
The other hose you are comparing has a rating of 4 ½ stars. The reviews say it works well, and there are no negative comments about the lifespan of the product. This hose costs $75. It also has a 4-year warranty. So, you have to decide – is it worth it to pay more than double for the nice hose which is likely going to outlast the cheap hose? Or, is it better to save money and just buy the cheap one? Even if you have to buy the cheap hose twice over the span of those 4 years, plus an extra nozzle, you’ll still end up with a lower out of pocket cost.
Why is it so important to know the cost?
The challenging thing is that the more expensive the item is, the more difficult it can be to determine price vs. cost. And knowing the difference between the price of an item, and it’s actual cost, is like knowing the difference between “I can pay for that”, versus “I can afford that.”
Where cost really matters
As we mentioned, the more expensive an item is, the more likely there is to be a difference between price and cost. Below are two examples of big-ticket items where it is essential to analyze the entire cost and not simply the price.
Buying a house
Buying a house is a big financial decision. Deciding what makes sense for your family, determining what you like and don’t like, and finding all of that in a single location you desire is difficult enough as it is. On top of that, you need to complete a financial analysis that goes well beyond simply considering the home’s price. What kind of additional information do you need to know beyond the list price?
- Homes will require annual maintenance which typically averages out to between 1-3% of the home’s purchase price.
- If you make a downpayment on your mortgage for less than 20%, you’ll likely need to pay for mortgage insurance on top of your mortgage payment. The average mortgage insurance costs between 0.5-1.5% of the loan amount per year.
- Typically you’ll be responsible for paying closing costs which can range from 2-5% of the home’s value.
- You’ll need to pay property taxes, which may or may not be lumped into your mortgage payments and can vary drastically depending on the home’s location. Some states, like Hawaii, charge less than half a percent. Other states, like New Jersey, charge much higher rates above 2.0%.
- Your homeowner’s insurance may or may not be rolled into your mortgage and the cost also varies drastically by state.
- Depending on factors like your credit score and what type of loan you qualify for, your interest rate will add to the to total cost of your home.
While this is not an exhaustive list, it is a real-world example where price and cost can diverge dramatically.
Buying a car
Buying a car is another common purchase many of us make where it is important to differentiate between price and the total cost. Again, analyzing price vs cost is akin to thinking “I can pay for that”, versus “I can actually afford that.”
Similar to house hunting, car shopping can get you into dangerous territory if you focus only on the sticker price or your monthly payment rather than the total cost.
- Whether you buy a new or used car, all cars require maintenance. The amount you pay will vary quite a bit based on factors like the age of the car, mileage, driving habits, brand, etc. Regardless, maintenance is a required additional cost of vehicle ownership. To establish a reference range, BMW’s rank on the high side with an average maintenance cost of $17,800 over the course of a ten year period. On the flip side, Toyota ranked much lower at only $5,500.
- Most states also require vehicle owners to carry car insurance. The cost of insurance depends on many factors, but the national average comes in at $1,427 per year.
- You’ll also be responsible for a variety of taxes and fees including sales tax, registration fees, vehicle license tax, title fees…and if you purchase your car from a dealership, you’ll also likely pay an additional dealership fee.
- If you finance your vehicle, you’ll also likely pay financing fees and additional interest on the loan.
- Fuel costs can also add up quickly and will vary greatly depending on if you opt to buy a gas guzzler or something more fuel-efficient.
The bottom line
None of this information is meant to deter you from buying a car or investing in a home. The important thing is that you do your homework and ensure you have a concrete understanding of what these types of large purchases will truly cost you and not just what the sticker price says.