The Pitfalls of No-Interest Financing
The New Year has come and gone, which means it’s time for the torrent of resolution-related ads for diet aids, exercise equipment and home products -- furniture in particular. No doubt, you’ve heard the pitch -- “No payments for 12 ... 24 ... 36 ... 48 months!” It’s as if the retailers are intent on mutually assured financial destruction. Or are they?
Deferred payment plans are as old as dirt; dating back to when the first merchant made a sale to the first customer who didn’t have enough rocks to pay for his club. On the surface, a deferred payment plan sounds like a good deal -- get the product today, pay for it tomorrow.
That’s fine, but what about the cost for this accommodation? Since it takes money to produce or acquire the product that’s being sold, and because it costs money to get money, the merchant will have to build that cost into his price if he wants to preserve a profit margin. Therefore, it’s reasonable to presume that when a furniture retailer offers a no-payments deal for a period of time, the customer will end up paying more for his sofa tomorrow than if he’d plunked down the cash for it today.
As it happens, this is the fundamental concept behind the time value of money: cash on the barrelhead today is worth more than the same amount tomorrow.
The reason is inflation. Today, $100 in hand is worth 2 percent more than the same amount a year from now when the rate of inflation is 2 percent. The reverse is also true: Money that’s invested today will grow as long as there’s a positive rate of return. So the same $100 invested today will be worth $102 this time next year, if the rate of return (interest) is 2 percent.
Here’s how all this comes into play with a furniture deal.
How it Works
The merchant has to pay for the goods he’s sold even though no cash is changing hands on the day of the sale. So he asks the customer to sign a promissory note to memorialize the customer’s obligation to pay for the furniture in full on a certain date in the future. The merchant can then take that note and use it as collateral for a bank loan. This process is known as discounting (or present-valuing) because the value of the customer’s future obligation is discounted to the value of today’s dollars. (If you’re curious, you can read about the formula here under the heading “Calculating the Present Value of an Annuity Due.”)
For example, let’s say the merchant’s bank prices the loan at 5 percent interest. Let’s also say the underlying deal is for $10,000 and it spans 24 months (two years). Using this time value of money calculator, courtesy of Zenwealth.com:
- Enter “10,000″ into the Future Value box because that’s what the customer will owe after two years.
- Enter “5″ into the Rate box because that’s the interest rate being charged.
- Enter “24″ into the Periods box because it represents the loan’s duration.
- Click the “Annual” drop-down menu and change it to “Monthly” because banks typically charge loan interest on a monthly basis.
- Now, click the “PV” button (which stands for “Present Value”) at the bottom of the tool to see the value for that two-year loan in today’s dollars.
The answer is $9,050.25, which represents the amount of money the bank would be willing to loan to the retailer today in exchange for the two-year, $10,000 promissory note that was signed by his customer. It also suggests that the merchant should be indifferent about accepting $9,050.25 from his customer today instead of jumping through an extra hoop or two with his bank. (Incidentally, you can take the same approach to determining the true cost of one of these arrangements when the price for the no-payment financing option is higher than it is for cash, as Gerri Detweiler explains in her article.)
Enter: The “Bullet” Loan
Few customers are in a position to pay cash for large purchases, which is why these types of single-payment, sales-inducing schemes -- known as bullet loans -- exist. The question is, do they put consumers at risk? Let’s play out a typical scenario for one of these things and we’ll see.
Say you sign a promissory note, get your bonded leather sectional and enjoy it for the next two or three years. One day, a notice comes in the mail reminding you that the full amount of your purchase will be due at the start of the following month. Will you be able to pay it off? I hope so, because the odds are you won’t be able to refinance this type of debt. Think about it. Two- or three-year-old furniture is worth a whole lot less than if it were brand new. The banks agree. That’s why they won’t be inclined to roll your note -- certainly not for the original amount, if at all.
Lengthy deferred payment plans are dangerous for precisely the same reason they’re so popular -- they separate the actions of buying and paying. (I have these same discussions with my students as it pertains to the interest-deferral period for their student loans!) So here’s how to make the right choices.
Test the value of the plan. Use a time value of money calculator to estimate the present value of the plan that’s in play and decide if it’s worth your while to save up and pay cash instead. Keep in mind that the higher the interest rate you plug into the tool, the lower the present value will be, which means the greater the value of the upfront discount you’ll enjoy. I suggest using a 5 percent interest rate until rates start increasing.
Budget for the payback. Be sure to set a calendar reminder for the date your deferred payment plan ends so you can be prepared for it. Then, set up a forced savings program by directing a portion of your net pay into a separate savings or investment account. You can estimate how much you’d need to set aside each month by using the same time value of money calculator.
- Enter the amount you owe into the “FV” (Future Value) box.
- Enter the duration of the deferred payment plan (in number of months) into the “Periods” box.
- Enter the interest rate you can reliably expect to earn on your money in the “Rate” box.
- Change the “Annual” dropdown menu to “Monthly.”
- Now, press the “PMT” (payment) button on the bottom to reveal the amount you’ll need to save each month.
Don’t get separated. Last but not least, no matter how enticing they may be, don’t let any type of payment plan tempt you into making a larger purchase than you intended. As much as financing can help us to afford the things we need and want -- particularly when cash is tight -- it can be just as easily used to help us get in over our heads too. That’s when the big problems hit home.
-- Mitchell D. Weiss is an experienced financial services industry executive, entrepreneur and adjunct professor of finance at the University of Hartford. He is also the author of the recently published College Happens: A Practical Handbook for Parents and Students and Life Happens: A Practical Guide to Personal Finance from College to Career-2nd Edition.