What is Payback Period and When Is it Useful in Personal Finance?
- Payback period is the amount of time it takes for an investment to pay for itself.
- It is useful because it is easy to calculate on the fly.
- Time value of money isn’t taken into account.
The payback period is the amount of time it takes you to break even on the original investment. Payback period is one of the simplest concepts to understand in finance which is one reason it is so useful. You should be able to calculate it on the fly making it one of the first personal finance analysis tools you learn to use.
Short payback periods increase your cash flow and allow you to tackle other projects or investments more quickly. Long payback periods, particularly of illiquid investments, have your money locked up for a long time and prevent you from using the money for other purposes during that time.
It’s a simple calculation to make and you should generally always make it when considering an investment that generates cash flows or reduces your expenses. Since payback period does not take time value of money or risk into account, you should not use it as the sole method of analysis however.
Calculating Payback Period
Calculating payback period is simple, it’s the cost of the investment divided by the annual cash flows it generates. The result is the time in years until you recoup your initial investment.
Payback Period(Years) = Purchase Price ÷ Annual Cash Flow
In personal finance you might replace annual cash flow with annual cash savings when considering purchases that reduce your expenses.
Common Uses of Payback Period in Personal Finance
Payback period is really useful when deciding on whether to take on investments which result in efficiencies and cost savings. It will tell you when you get your initial investment back. Some commons examples relevant to personal finance where payback period is useful are:
- Choosing the best home efficiency improvements
- Determining if you should pay more for high efficiency appliances
- Comparing a gas to a hybrid version of a car
- Evaluating solar panels
- Determining if you should refinance your mortgage.
Examples of Finding Payback Period in Personal Finance
- Standard Efficiency vs High Efficiency HVAC – Let’s assume your HVAC system needs to be replaced and you have been quoted $5,000 for a standard efficiency model and $6,500 for a high efficiency model. The contractor estimates that the high efficiency system will reduce your utility bill by $750 annually.
The payback period for the upgraded HVAC system would be ($6,500-$5,000)/$750= 2 years.
Considering the relatively short payback period you would probably opt for the higher efficiency model if you had to cash on hand to pay for it. You would have your $1,500 back in hand in 2 years.
- Hybrid or Gasoline Powertrain – You are in the market for a new Honda Accord. You are looking at the standard LX model for $24,020 that gets 33MPG. You see the comparable hybrid model for $25,620 that gets 48MPG. Based on your miles driven you expect to save $300 per year in fuel costs with the Hybrid Accord.
The payback period for the Hybrid Accord would be ($25,620-$24,020)/$300= 5.3 years.
This would be a moderate breakeven point and you would want to perform more analysis before making a decision.
- Tesla SolarRoof Upgrade – You have grown tired of paying $2,000 in annual electric bill and decide you want to go off the grid using a Tesla SolarRoof. You use their online calculator and come up with $48,220 installed on their recommended roof.
The Payback Period for this would be 24.1 years! This is too long of a time for payback period at be a good analysis tool to use in this situation.
Problems with Payback Period
Payback period is most useful when evaluating short term projects for viability. It does not take the risk of a project or the time value of money into account. For longer term projects the risk and time value of money should not be ignored.
Payback period is also only concerned with breaking even. It does not take into account the overall profitability of a project. A home improvement thats lasts 15 years and pays for itself in 5 years may not look great under payback period Once you account for time value of money and the extra 10 years of savings it may clearly be a good idea though.
Payback period should be one of the first financial analysis tools that you learn to use. It is heavily used in capital finance but also has numerous applications in personal finance. Once you are comfortable with the concept you can calculate it on the fly to quickly evaluate financial opportunities.
Choosing short term payback period projects allows you to get your money back quickly so that it can be reinvested somewhere else. Unless you have infinite money, you should always make payback one of the first considerations you make when analyzing a potential project.