Close your eyes for a moment. Imagine you’re on a college campus in fall, kicking leaves as you cross a quad. You’re a freshman and you’ve left all your high school hang-ups back in your hometown. In the coming days you’ll make new friends and learn new subjects. You truly get to reinvent yourself.
How often does this happen in our lives? In reality, most people have only a few chances to put the past behind them. Sometimes we get new jobs or move to new towns. But more often than not, we stay the same.
I’m not a life coach or a therapist. I write about finances and this is a financial article, even though it may not seem like it yet.
While we can’t often reinvent our whole lives, when it comes to our finances we can live each day as a new person as long as we understand the sunk cost fallacy.
Sunk cost has a fairly simple definition: money already spent that cannot be recovered. It could be the negative equity of our underwater house. It could be the tanking stock that we’re waiting to rally, or the bad debt we’ve put on auto-pay and done our best to forget about. Given a bad situation, a person succumbing to the sunk cost fallacy tries to wait out their situation. They hold the bad stock, keep the bad house. They make bad financial decisions today because of emotions tied up in decisions made yesterday. Conversely, a person who understands sunk cost makes the best decision for the future without considering the past at all.
This simple explanation belies a profound concept. Simply, that we can unburden ourselves of our past financial mistakes and live fully in the present. It’s the only money concept I’m aware of that can double as a life philosophy.
Let me be clear: I’m not saying we can just erase our past mistakes. No fairy godmother is coming for our credit card debt. What I am saying is that understanding sunk cost allows us to separate emotion from financial reality. And once we’ve skimmed out our emotions, we can tackle problems head on in the most efficient way that math allows.
Let me give you an example. For years I had a second mortgage of $40,000 that I’d gotten to avoid paying PMI. It carried high interest payments and I think a mad scientist wrote its terms. The rate rose at unexpected times and it had a balloon date built into it (meaning the whole loan was due at some point in the near future). Worst of all, it was interest only, meaning that I was billed only for interest and had to choose whether to pay down its principal each month. If I didn’t pay extra, the term of the loan was essentially infinite - until it wasn’t.
In short, this loan was bad news. For almost ten years I paid the minimum automatically, throwing away the monthly statements unopened as soon as they came.
Sounds pretty terrible, no? Well what if I also told you that I had the resources to pay off my loan within three months? It’s true. As I got older I got some raises. I saved more and opened a mutual fund account. I met a girl who would go on to become my wife; she moved in and for a few years we experienced the glory that is double-income-no-kids.
To crush this mortgage, all I had to do was sell a few mutual funds, tap an online savings account and scrimp for a few months. Any rational person would have told me to either sell the house or tackle the debt immediately through payment or refinancing. But for years I avoided making a decision, losing thousands of dollars in the process. Somewhere deep inside, past any logical decision making, I was ashamed of my bad decision. I partly thought that if I just waited long enough a perfect option would appear out of thin air. I didn’t understand the sunk cost fallacy, or at least I wasn’t willing to confront it.
Then one day with some help from my wife, I did. Within three months, I paid off my $40,000 loan. It was a moment I’d dreaded, when I would admit my mistake and spend more money than I’d ever spent in my life to atone. Instead, I didn’t even miss the money, and the dread never came. Instead I felt a perfect lightness. I was a new person, like the past ten years hadn’t happened.
This is the power of understanding sunk cost: it’s the difference between living in the present or dwelling on the past.