A friend recently asked “what does 18 months ‘interest free’ mean to you?” In his informal survey, half the people he questioned thought – like him – it meant no interest will be charged until the 19th month. Unfortunately, it is not that simple.
When purchasing on credit, always anticipate paying interest (cost of money) on the money borrowed. In the current economy, interest rates are unusually low, and it is easy for companies to offer deals wherein they absorb the cost of money in exchange for making a sale, but beware of the ‘Interest Free’ traps:
1. Interest starts accruing on day one
Interest accrues and is tracked on an ‘interest free’ loan from the beginning, and will be added to the loan balance if the terms of the ‘interest free’ loan are not met. These terms may be complex and are often not understood by the salesperson offering them.
2. Typically, the interest rate is higher
The underlying interest rate on the loan will typically be higher compared to a loan which does not have an ‘interest free’ option. Therefore, failing to meet the terms of an ‘interest free’ loan may be costly.
To give his home a facelift, Jake painted the interior over a couple of long weekends. Done with the mess and hassle, he contracted with a floorings company to redo the carpets throughout the house. They offered a 36 month interest free purchase plan with the following terms:
- $10,000 principal loan amount;
- $193.72 monthly minimum payment;
- Full payment due in 36 months;
- 19.99% interest rate, if the terms are not met.
3. Cannot miss a payment
Payments must be made on time. Missing a payment often invalidates the terms of loan resulting in all accrued interests being added to the loan balance.
For example, let’s say Jake makes 12 monthly payments of $300, considerably more than the minimum due, but misses the payment cutoff date the 13th month.
When Jake opens his bill in the 14th month, he is shocked to see $2,120.88 in interest has been added to his loan balance.
4. Must pay loan in full by the end of the term
If sign reads “Interest Free for 12 months”, it means interest free when paid off within 12 months. The advertised time frame is more of a deadline than an offer.
For each of the first 35 months, Jake makes a payment of $250. Now on the 36th month Jake must either pay the balance in full ($1,250), or be charged all accrued interest. Jake was unable to pay the loan in full, so he sent in another check for $250.
When Jake opens his bill in the 37th month, he is shocked to see $5,029.72 in interest has been added to his loan balance of $1,000.
5. Must pay more than the minimum payments to get interest free financing
The creditor will require a minimum payment each billing cycle. The minimum payment will be clearly printed on each bill. Yet they fail to mention that making the minimum payments will not pay the loan off in time to qualify for the interest free financing.
When Jake receives his first bill, the minimum payment is $193.72; however, Jake would have to make a monthly payment of $277.78 in order to pay the loan in full within 36 months.
Assuming Jake pays only the minimum payment for the first 36 months; on the 37th month $5,794.72 in interest will be added to Jake’s loan balance of $3,026.08.
It is easy to be burned with interest free financing; however, if you meet the terms, it can be beneficial. Doing it right, Jake makes a payment of $285.72 (loan amount / # of months – 1) for each of the first 35 months of his loan.
When Jake opens his bill in the 36th month, he finds that the balance of his loan is zero, and he ended up saving $4,474.42 in interest payments over the course of the 36 months. Had he paid the loan over the course of 10 years, it would have cost him $13,046.96 in interest payments alone.
Unfortunately, the terms are rarely easy to understand and never, I repeat, never, assume that the salesperson knows anything more than the hype of the offer. However, as long as you understand these offers, there is nothing wrong with using them. Just make sure you give yourself a cushion, and divide the total amount due by the months available less one like Jake did in the end.