Friction Cost

What Is Friction Cost?

Friction cost is the total direct and indirect costs associated with the execution of a financial transaction. The friction cost comprehensively takes into consideration all of the costs associated with a transaction. Calculating the friction cost provides an investor with a full range of expected costs they can expect to incur.

How Friction Cost Works

The friction cost can help an investor to evaluate a transaction from every possible angle to determine all of the direct and indirect costs. Rather than just looking at the ticket price, which can often be misleading, the friction cost method is the broadest comprehensive calculation an investor can use when considering a potential transaction. Using the friction cost method when comparing products can help an investor or borrower to make more informed decisions and rule out high-cost products that could be easily substituted with more efficient investments. The friction cost is ultimately what the "end cost" would be on an investment. Two investments may have the same price per share, but a high expense ratio on one would increase the ultimate friction cost of making that investment.

Friction Cost Considerations

A broad array of costs are considered when calculating the friction cost of an investment. When investing in mutual funds through a full-service broker, friction costs can include commissions and fees along with the total investment. An investor may also subtract a subjective value from the cost of investment for foregone research time, which was not required by the investor to identify the investment. Thus, often, the total friction cost value will be dependent on certain arbitrary values explicitly assigned by the investor.

In this area, friction costs are one of the main drivers of the start and growth of robo-advisors. Robo-advisors reduced friction costs via the use of technology and the switch from mutual funds to ETFs seeking fewer expense ratios and human time for advisory and investment services.

Analyzing Credit Options

Alternative credit products can be an important category for using the friction cost calculation method to arrive at financial decisions. Credit products often include a variety of fees that make friction cost analysis importing in due diligence.

A mortgage loan, for example, includes several expenses. The basic expenses will be the principal and interest paid to the lender in monthly installments. Other costs in friction cost analysis may also include an application fee, an origination fee, a broker fee, an appraisal fee, a credit report fee, tax service fee, underwriting fee, document preparation fee, wire transfer fee, and other office administration fees. Often these fees will be bundled in a points fee quote, though they may also be required individually. Assessing not only the interest charged on a mortgage loan but also its fees in a friction cost analysis can help a borrower obtain a better understanding of their comprehensive costs and also compare costs across other market options.

Friction cost analysis can also be especially important when considering alternative loans. For example, payday loans can charge investors up to approximately 400% in interest annually while also including fees. Adding the principal and interest with the potential origination fees, service fees, and other costs associated with a payday loan will typically make other credit market options much more appealing.