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 to 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.”

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 on 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 some homeowners may be contemplating once mortgage rates come back down. 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 for 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. When gas prices are 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.

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Reviewed October 2023

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.