I heard on the radio an ad from a mattress store. It says for this weekend only, the store will either pay the sales tax on any mattress purchase or give free financing for 24 months.
Suppose the price of the mattress is $1,000 and the sales tax is 8% (to make math easier), if the customer chooses free sales tax, the customer will pay $1,000 out-of-the-door, sales tax included. If the customer chooses free financing, the customer will pay $1,000 + $80 sales tax = $1,080 over 24 months. That’s $45 per month.
Because the financing customer loses the free sale tax discount, "free" financing isn’t really free. The customer is basically borrowing $1,000 to buy the mattress now and paying it off with $45/month for 24 months for a total of $1,080.
What’s the interest rate in this "free" financing loan?
Without a computer or calculator, here’s how to quickly estimate the rate. The balance goes down from $1,000 to zero in two years. Therefore the average balance in these two years is $500. You pay $80 for borrowing $500. That’s 16% over two years. Divide by two, you get 8% per year. Take into consideration some compounding, the rate is slightly lower, probably between 7.5% and 8%.
Do you think the customers know how to do this when they face the choice between free sales tax and free financing?
Financing offers are a great tool to promote sales. If the store only offered free sales tax, it wouldn’t be able to sell to customers who don’t have enough cash on hand. If the customers don’t have enough money when the price is $1,000, they still don’t have enough money if you lower the price to $930.
"Free" financing solves the problem. The store gets money for the mattress. Its financing partner collects interest. The customer gets a new mattress. Everyone is happy. What about that $45 per month? That’s forced savings. The customer’s sore back will thank the financing magic.
I saw another ad on a billboard when I drove on the freeway the other day. It said:
I wondered why this deal didn’t exist when I was a kid. My parents couldn’t afford braces for their kids. As a result, I don’t have straight teeth.
We should thank those people who provide financing to consumers. Without them, retail sales will suffer, more people will have back problems from bad mattresses, and fewer kids will have straight teeth. Consumer financing, more than GE, brings good things to life.