I often read on the blogs when someone talks about their insurance

my ___________ (life, car, home, …) insurance is $______ a month.

or

I saved $_______ a month on my ____________ insurance.

So it seems that a lot of people pay their insurance by month. I’ve always paid my insurance in a single payment because insurance companies typically charge a small *processing fee* or *service fee* if you choose to pay by month. That service fee looks like a finance charge to me. No other business charges its customers by the *number* of times the customer pays. The reason the insurance company charges extra is because it extends credit to you if you don’t pay the entire premium when it’s due, the same way the credit card company charges you interest if you don’t pay the balance in full. What the insurance companies call *service fee* is really interest or finance charge in disguise.

I received the bill for my car insurance renewal last week. Here are my options:

- Make one payment for $736; or
- Make four payments of $184, plus a $4 service fee for each payment.

So if I take the 4-payment plan, I will pay $752 over 4 months, $16 more than the $736 premium due. That’s only a little over 2% of the premium. Not bad for making it easier on the budget? **Not so fast.** I decided to take a closer look at the embedded interest rate in the 4-payment plan. Here’s the insurance company’s cash flow for the 4-payment plan:

10/31/2006 | -736 |

10/31/2006 | 188 |

12/1/2006 | 188 |

1/1/2007 | 188 |

2/1/2007 | 188 |

The interest rate turns out to be … … **19%**! Wow, taking the 4-payment plan amounts to charging it on a credit card and paying 19% interest!

To calculate the interest rate, you need the XIRR function in Excel or OpenOffice. I made an Excel spreadsheet for this exercise. You can download it here. If your insurance company charges you a service fee for paying by month, plug in your own numbers and see what interest rate they are charging. If you don’t mind, please post in the comments the company, product and the built-in interest rate on their payment plans.

If you want to learn more about the XIRR function, please read this post by Ricemutt at Experiments in Finance.

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rickk says

I don’t get it ðŸ™‚

Where does that 19% come from?

Anonymous says

Rickk and TFB,

This is a bit tricky to explain, I am not able to get quite to 19% but I can get a good way there.

From your perspective, your effective interest rate is 12.1%. From the companies point of view, their return on investment is >15%. You can get 12.1% using relatively straightforward logic. TFB’s point (an apparent 2% cost is really something substantially more) has been very well made. Unless you have a foolproof way to invest your money at a yield of 12.1%, pay it up front if you can.

The way I thought about it is this: how much is the insurance company loaning you and when?

In the case where you pay the company everything up front, they are loaning you no money for no time.

According to TFB’s table: With the installment plan, you pay 188 at the beginning (the company is owed 552 – remember 4 of that is charge), then 2 months later pay another 188 (the company is owed 368), then one month later you pay another 188 (the company is owed 184), in another month you pay 188 again at which point the company is owed nothing.

You can think of it this way: You borrow:

you borrow 184 for 4 months.

you borrow an additional 184 for 3 months.

you borrow a last 184 for 2 months.

The maximum YOU borrowed is 552. The cost of these loans must be $16 which is about 12.1%.

Here is where it gets tricky TFB’s notes that the insurance company’s net outlay is only 548 (they got your $4 charge at the beginning so are only 548 out of pocket NOT 552). Therefore, from their perspective:

172 for 4 months.

188 for 3 months.

188 for 2 months.

At the end of this 4 month period they are $16 ahead. This gives them a return of 12.4%.

If you consider the fact that they do this twice and the second time around they are only $532 out of pocket (having received the $16 from you) AND they have a different repayment schedule (this one take place over 3 months not 4!) this gets to almost 15.4% annual return.

I can’t quite get to the 19%, but I suspect it is computed correctly and probably takes into account the exact dates of booking the payments and that this is only 7 out of 12 months.

The big point here is that the 2% is incorrect since even in the first instance this represents 4 months. The annual yield for the insurance company even if they let you put off paying anything to the end of the 4 month period is over 6%.

Harry Sit says

Rickk,

The 2nd comment is on the right track, except he/she is off by one month. Without using Excel spreadsheet and function, here’s the back-of-envelope calculation. In my example, the insurance company loans you $184 for 1 month, another $184 for 2 months, and a third $184 for 3 months. If you average out the first and the third installment and make them both $184 for 2 months, you are borrowing total $552 for 2 months. For that 2 months, you interest cost is $16/$552 = 2.9%. Compound it 6 times for an annualized rate, you get (1 + 2.9%) ^ 6 – 1 = 18.7%.

eve stefani says

I don’t mind paying interest on something I have ie a stove, or a car. But insurance is something I use on a monthly basis. If I were to pay for the year in advance I am in effect loaning them money and should get a huge discount or paid interest on that money. And is it legal? To pay for something I haven’d used seems not quite right, and to charged for not doing it doesn’t make sense.

Yadi says

I aggred with you!!!

Harry says

You have the full value of the insurance from day one. If you have an accident in the first month, they will pay the full amount, not just 1/12th. If you pay monthly, you are actually borrowing from them.

Mike V says

Not true. If I pay monthly I am covered for the month that I paid. If I do not pay for a month I will not be covered. So, how can they charge me interest/finance charge on a loan I never received. Example: My policy is 1900.00 per year. You are saying they pay that up front to themselves and I pay them back. No way they are doing that. They are not extending anything to me. There is nothing tangible, like say a mortgage, auto loan, line of credit etc. If I default on any of the aforementioned, It will show up on my credit report. If I default on car insurance nothing happens to my credit or finances. Why? Because it’s not a loan. They are basically charging a service fee, which makes more sense and certainly most consumers would understand a service fee.

David Sanchez says

Here is the worst part. They are actually not really loaning you anything. you are better off If you borrow the money from another institution (even at the same rate). If you borrow the money and pay the insurance, then it is paid off. If you default on the loan, your insurance is till good. However, if you miss a payment to the insurance company they cancel your insurance. They are having the best of both worlds. They charge you interest on money that you really haven’t borrowed at all. It’s a scam!

Mike V says

Correct! Why is that legal? And, why can’t the average person understand what they are doing?