How to Calculate Payback Period on an Investment

Investment opportunities come in many shapes and sizes. There are household investments like installing energy-efficient windows that can save money in the long run. There are business investments like new equipment or office space that can fuel future profits. And there are traditional investments like stocks, bonds and real estate. If you’re in a financial position to start investing, one key term you’ll need to know is “payback period.”

What is a payback period?

Not to be confused with a loan repayment schedule, “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 see that you’re spending too much in energy costs for your house or business. You bring in an energy expert who suggests installing solar panels, which can save you $1,500 each year on your electric bill. He tells you the entire project will cost $15,000. Before you commit to making this investment, you 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

Cost of Investment ÷ Average Annual Cashflow = Payback Period

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

    $15,000 (your upfront investment)
÷    $1,500 (your annual savings)
= 10 years

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

But keep in mind that unlike other methods, this payback period calculation ignores the time value of money (TVM). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money.²

What is a good payback period?

It all depends on the kind of investment, how much you’re willing to risk and how long you’re willing to wait before you recoup your investment. But in general, the shorter the payback period, the better.

Consider this payback period example: Let’s say you have the opportunity to be a partner investor in purchasing an apartment building. Your initial investment is $20,000 and you are guaranteed $6,000 in rent from tenants each year.

Using the payback period formula:

    $20,000
÷    $6,000
= 3.3-year payback period

That means, in a little over three years, you will have gotten back the $20,000 you initially invested and will starting making a profit.

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 finding investment opportunities that promise the most positive impact at a risk level you’re comfortable with.

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1,2. https://www.investopedia.com/terms/p/paybackperiod.asp
3. https://paintingbusinesspro.com/how-to-start-a-painting-business-from-scratch/