What Are Transaction Costs? Definition, How They Work, and Example

What Are Transaction Costs?

Transaction costs are expenses incurred when buying or selling a good or service. Transaction costs represent the labor required to bring a good or service to market, giving rise to entire industries dedicated to facilitating exchanges. In a financial sense, transaction costs include brokers' commissions and spreads, which are the differences between the price the dealer paid for a security and the price the buyer pays.

Understanding Transaction Costs

The transaction costs to buyers and sellers are the payments that banks and brokers receive for their roles. There are also transaction costs in buying and selling real estate, which include the agent's commission and closing costs, such as title search fees, appraisal fees, and government fees. Another type of transaction cost is the time and labor associated with transporting goods or commodities across long distances.

Transaction costs are important to investors because they are one of the key determinants of net returns. Transaction costs diminish returns, and over time, high transaction costs can mean thousands of dollars lost from not just the costs themselves but also because the costs reduce the amount of capital available to invest.

Fees, such as mutual fund expense ratios, have the same effect. Different asset classes have different ranges of standard transaction costs and fees. All else being equal, investors should select assets whose costs are at the low end of the range for their types.

Ongoing vs. Transaction Costs

Though similar in nature, ongoing fees and transaction costs are technically different. Ongoing fees are fees that are charged periodically over the life of the product or service. These fees are typically associated with products or services that require ongoing maintenance or management such as being involved in an investment fund. Transaction costs are fees that are charged each time a specific transaction occurs. Both types of fees may be percentage based on a related dollar amount or related to a fixed dollar amount.

This distinction is important, especially when reviewing what your broker offers. Though you may go to great lengths to avoid transaction costs, your broker may still impose quarterly ongoing fees that can not be avoided as long as your brokerage account is open. In addition, there may be opportunities to incur one type of transaction in exchange for another. For instance, some brokers may charge an ongoing fee for certain account access that gives greater incentives such as lower or no transaction costs.

Elimination of Transaction Costs

When transaction costs diminish, an economy becomes more efficient, and more capital and labor are freed to produce wealth. A shift of this nature does not come without growing pains, as the labor market must adjust to its new environment.

One type of transaction cost is a barrier to communication. When an otherwise perfectly matched seller and buyer have absolutely zero means of communication, the transaction costs of a deal are too high to be overcome. A bank serves the role of the middleman by connecting savings with investments and a prosperous economy justifies the income of the bank for the transaction cost of compiling information and linking parties.

However, the Age of Information, specifically the influx of the internet and telecommunications, has greatly reduced barriers to communication. Consumers no longer need large institutions and their agents to make educated purchases. For this reason, the survival of the insurance agent is being jeopardized by a wide range of technology startups that run websites either selling or promoting insurance policies. The easy access to information and communication that the internet provides has also threatened the livelihood of jobs, such as the real estate agent, stockbroker, and car salesman. It is considered to be what destroyed Scottrade.

In essence, the prices of many goods and services have lowered due to a reduction in barriers to communication between everyday individuals. Retailers and merchandisers serve the role of middlemen as well, by pairing consumers with manufacturers. With the rise of e-commerce transactions, consumers may find it more efficient to enter into digital transactions to have their consumption needs met. However, in many ways, this has simply shifted the type of transaction cost incurred in respect to brick-and-mortar services.

Example of Transaction Costs

According to Fidelity, the load for mutual funds ranges from 1% to 2%. This load fee pays the brokers as an incentive for choosing one mutual fund over another. Fidelity also notes that financial advisors may receive payment via commission or an annual percentage of your entire portfolio. The annual percentage often ranges between 0.5% and 2.0%.

Also consider that most mutual funds may charge an investor a marketing fee called a 12b-1 fee. This fee may range from 0.25% to 1% depending on whether the fee is front-loaded or back-loaded. As opposed to many other types of mutual fund fees, this fee is usually a one-time transaction. Though it's often disclosed as a marketing fee, a wide majority of the 12b-1 fee is often paid to the broker who sold you the fund.

The Bottom Line

Transaction costs are often necessary to reward intermediaries to facilitate the exchange of a good. This is especially prevalent in the investment world where brokers, regulatory agencies, or other entities impose fees on trades or transactions. Be mindful of the fees your broker charges, and consider implementing strategies such as bulk trades, passive investing, or fewer contracts to minimize these fees.