How to Calculate the Payback Period on an Investment

Investment opportunities come in many shapes and sizes. Household investments like installing energy-efficient windows can save money in the long run. Business investments like new equipment or office space can fuel future profits. If you’re in a financial position to start investing, one key term you’ll need to know is the “payback period.”

What is a payback period?

Not to be confused with a loan repayment schedule, a payback period has nothing to do with how long it takes to pay back a loan. The payback period is the amount of time it takes to recover the cost of an investment.¹ In other words, “How long until this investment pays for itself?”

For example, you might notice that you’re spending too much on energy costs for your home or business. You bring in an energy expert who suggests installing solar panels, which may save you $1,500 each year on your electric bill. The expert tells you the solar panels will cost $15,000. Before you commit to installing solar panels, you’ll want to know how long it will take for the money you’ll save in energy costs to equal the $15,000 you’re investing upfront. This period of time is the payback period.

Calculating a payback period

To calculate the payback period, you divide the cost of the initial investment amount by the average savings or cash flow from the investment (which, in this case, is the solar panels).

Using the payback period formula, the amount of time until the solar panels pay for themselves would be:

$15,000 (the cost of the initial investment) ÷ $1,500 (your annual savings) = 10 years

That means, after year 10, you should break even on your initial investment and will pocket the $1,500 savings each year thereafter. If you’re planning on living in your home or running your business in this location for more than 10 years, this payback period could be worth the investment.

What is a good payback period?

What’s considered a good payback period varies depending on your personal situation. When you’re evaluating a payback period, consider the kind of investment, how much you’re willing to risk and how long you’re willing to wait before you recoup your investment.

Consider this payback period example: let’s say you own a small nail salon, and you’re investing in a website redesign that will allow clients to make and pay for appointments online. The change will free up time you usually spend manually managing your schedule, so you can fit in a few additional customers each month. Your initial investment is $10,000, and you estimate you’ll get an additional $6,000 in annual cashflow from new clients each year.

Using the payback formula:

$10,000 (cost of initial investment)

÷ $6,000 (average annual cashflow)

= 1.7-year payback period

That means in a little under two years, you will have earned back the $10,000 you initially invested.

Pros and cons of using the payback period formula

Using the payback period formula to assess an investment has some benefits and drawbacks. Knowing the pros and cons can help you decide when it’s most useful and when you might want to look at other tools instead.

Pros

• Simplicity: You only need two pieces of information to calculate the payback period: your initial investment and your annual savings or cash flow.
• Quick assessment: You get a quick measure of how soon you can expect to recover your initial investment.
• Helps gauge risk: Calculating the payback period can help you assess the risk of longer-term projects.
• Helpful comparison tool: The payback period formula is an easy way to compare several potential investments with differing costs and returns.

Cons

• Ignores the time value of money: Money becomes less valuable over time. Inflation or changes in cost of living can make the money you earn worth less.² For this reason, the payback period formula may not be helpful for longer-term investments.
• Doesn’t measure profitability: The payback period formula doesn’t account for any money you earn after the payback period ends. It only measures how long it will take you to break even.
• Doesn’t include additional costs: The payback period formula doesn’t factor in ongoing costs. For example, you might need maintenance or repairs on new equipment after a few years.
• Doesn’t give a full picture of risks: The payback period formula doesn’t account for risks beyond your initial investment. If your business takes a downturn, for instance, you may not earn or save as much as you expected.

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Weigh the pros and cons of any investment carefully

Before committing to an investment, consider all factors, including the payback period, to determine whether it’s a worthwhile opportunity. Whether you’re looking into investing in a business startup, expanding your current business, buying stocks or purchasing real estate, every investment comes with some degree of risk. Make sure you’re comfortable with the way your investment opportunities balance impact with risk and consider speaking with a financial advisor if you need more guidance.

Sources:

1,2. https://www.investopedia.com/terms/p/paybackperiod.asp

This article has been updated from a previous posting in 2022. Kia Jackson contributed.