Using ROI to Make Better Financial Decisions

by Gary Foreman

Return on investment, or ROI, is a tool used by businesses all the time to make better decisions. Learn how ROI can help you make better personal finance decisions. too.

Gary,
I once read about using ROI to determine whether a certain purchase was saving time, energy, or money. Could you write up a story with the ROI formula and how to use it?
Wendy

Wendy has a good idea. Adapting business tools to your personal finances often helps take the emotion out of a decision so that you can make a logical choice. So how can you use ROI at make better financial decisions?

How to Calculate ROI

The idea of ROI (Return On Investment) is fairly simple. A business investment should save or make money. The ROI calculation is an attempt to determine how much each dollar invested will return. If a business has limited resources, only the highest ROI projects would be financed.

To calculate the ROI, you take the value of the benefits and divide by the value of the costs. When professionals use these tools, they’ll often use complicated formulas that take into account that having $1 today is worth more than one you won’t get until next year. Fortunately, in most personal applications, that’s simply not necessary.

Let’s suppose that a business could make a $500 investment that would produce $700 of extra profits. The benefits are $200 ($700 extra profits minus $500 invested). Divide the benefits by the investment ($200 / $500 = .4) to get an ROI of 40%.

How to Determine the Payback Period

The obvious shortcoming of the model is that you need to make some assumptions as to how much you’ll save. So many businesses also consider how long it will take to recover the initial investment. That’s called the “payback period.”

We can help you gain control of your finances and live better...for less.

Subscribe to Financial Independence, our daily email newsletter. It doesn't cost anything. And, it could make a huge difference in the way you live!

Debt ChecklistSubscribers get Are You Heading for Debt Trouble? A Simple Checklist and What You Can Do About It for FREE!

Your Email:

We can help you gain control of your finances and live better...for less.

Subscribe to Financial Independence, our daily email newsletter. It doesn't cost anything. And, it could make a huge difference in the way you live! Subscribers get Are You Heading for Debt Trouble? A Simple Checklist and What You Can Do About It for FREE!

Your Email:

Using ROI to Make a Purchase Decision

Let’s see how it works. First, an easy one. You compare the yellow energy efficiency label from your 12-year-old refrigerator to one on a brand-new model. According to the labels, you should save $65 per year in electricity. The new refrigerator costs $449. If you use the new fridge for 12 years, you’ll save $780 ($65 x 12 years). So the ROI is 73%. ($780 – $449 = $331 and $331 / $449 = 73%)

That’s interesting, but should you buy the fridge? You might get a more useful answer by considering the payback period. If you save $65 per year and pay $449 for the refrigerator, it will take 6.9 years before you’ve recovered the cost of the fridge ($449 / $65 = 6.9 years). So unless you plan on using it for more than 7 years, you should pass up the purchase.

Using ROI to Decide on a Mortgage Refinance

Next, let’s look at a case that most homeowners are familiar with. You’ve been in your home a couple of years and mortgage rates have dropped. Should you refinance to take advantage of the lower rates?

To answer the question, let’s consider the payback period. Begin with the cost to refinance. That’s the investment. Next, how much you’ll save each month (AKA: the benefit). Then you can calculate how long it will take to make up the cost. Suppose that refinancing triggers $3,000 in various costs. But, you’d save $125 per month. You could calculate that it would cost you 24 months before you had recovered your investment ($3,000 divided by $125 = 24 months). So if you’ll be in the home more than two years, it’s a good idea to refinance.

Using ROI to Decide on a Car Purchase

One final example. You’d like to replace that old 9 MPG gas guzzler. The new car you like gets 23 MPG. With gas prices so high, doesn’t it make sense to spend $19,000 to trade for the new car?

We’ll begin by figuring out how much we’d save each year. You drive 18,000 miles each year. So the old car uses 2,000 gallons of gas (18,000 / 9 MPG). At $2.50 per gallon, that’s $5,000. The new car would only use 782 gallons or $1,955 per year. So you’d save $3,045 per year ($5,000 – $1,955). Your insurance would also drop by $200 per year. That brings the total savings to $3,245 per year.

So what’s the payback period? Divide the trade-in price of the car ($19,000) by the annual savings ($3,245) and you get 5.8 years. So you can’t quite justify this car trade based on gas and insurance savings alone.

Start Using ROI to Make Better Financial Decisions

You’ll notice that in each case you need to think through the process a little. Usually the hardest part is estimating how much you’d save with the new item. Just remember that this isn’t an exact science so do the best you can with any assumptions.

Many spending decisions are hard to analyze. You can use this same process to calculate whether it’s worthwhile buying compact fluorescent bulbs or a new furnace. By breaking a decision down into an ROI or payback type of calculation, you’ll have a framework for making a better financial decision.

Reviewed August 2019

About the Author

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.

Let us help you achieve your financial goals.

Subscribe to Financial Independence, our daily email newsletter. It doesn't cost anything. And, it could make a huge difference in the way you live!

Debt ChecklistSubscribers get Are You Heading for Debt Trouble? A Simple Checklist and What You Can Do About It for FREE!

Your Email:

Follow Us

We can help you gain control of your finances and live better...for less.

Subscribe to Financial Independence, our daily email newsletter. It doesn't cost anything. And, it could make a huge difference in the way you live!

Debt ChecklistSubscribers get Are You Heading for Debt Trouble? A Simple Checklist and What You Can Do About It for FREE!

Your Email:

5 Surprising Ways Shorter Days Affect Your Budget

Does it seem like your budget gets tighter as the days grow shorter? Here are 5 things that may be to blame and what you can do to keep these sneaky costs in check.

Before You Toss Food, Read This: What to Know about Food Expiration Dates

If you throw out food that is past it’s expiration date, you just might be throwing out your money unnecessarily. Here’s the scoop on food expiration dates and when you should and shouldn’t abide by those dates.

Moving Back in with your Parents: 15 Ways to Make it a Positive Experience

Moving back in with your parents won’t necessarily make your life better. But here are 15 steps that can help make it a positive experience.

How a Full Pantry Saves You Money

How much food is in your pantry? Then more you have could mean the more you save. Here are 6 rules to help you stock up simply and inexpensively.

The Money-Saving Benefits of Making Lists

Could the simple task of making lists really improve your finances? First, consider these money-saving benefits of list making, and then get into the habit of making your own lists.

Pin It on Pinterest

Share This