*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 home finances often helps take the emotion out of a decision so that you can make a logical choice.

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 home 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%.

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.”

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.

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.

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 $1.50 per gallon, that’s $3,000. The new car would only use 782 gallons or $1,174 per year. So you’d save $1,826 per year ($3,000 – $1,174). Your insurance would also drop by $200 per year. That brings the total savings to $2,026 per year.

So what’s the payback period? Divide the trade-in price of the car ($19,000) by the annual savings ($2,026) and you get 9.3 years. So you can’t justify this car trade based on gas savings.

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 decision.

*This article by Gary Foreman first appeared on The Dollar Stretcher and was distributed by the Personal Finance Syndication Network.*