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.
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Financing makes everything cost MORE. If people stopped using financing, and made purchase with cash out of their savings, we would have more consumption and things would be less expensive.
If your parents could pay $99/mo for two years to buy you braces, they could have more easily paid $88/mo for two years (or whatever) before you got braces.
Isnt the interest rate on $1080 far lower than 8%.
this is how I calculate …
CI = Prin (1 + R/100)^N
…. the compunding Interest relationship we learnt in high school. Please excuse my typing. See http://en.wikipedia.org/wiki/Compound_Interest
1080 = 1000 (1 + R/100) ^ 2
R = 3.93 %
Am I wrong? Please advice.
Harry Sit says
@nick – Of course financing makes everything cost more. The cost of financing has to come from the consumers. However I don’t agree if everyone uses cash, there would be more consumption. Financing creates demand from people who don’t have cash. When everyone could get a mortgage, people bought more houses, more refrigerators, and more furniture. When people can get student loans, more people go to college. Credit feeds consumption.
Mortgages are an exception because of their size. Anyone who can afford to finance $2000 braces (paying interest) could also have afforded to save up for those same braces (earning interest), and then gone out and consumed again with that extra money that was saved. Hence, more consumption. It is delayed consumption, but on the whole it is higher consumption.
Harry Sit says
@Compounder – If you borrow $1,000 and pay $1,080 at the end of two years with no payment before then, you would use your formula and get 3.9%. In my example you make monthly payments (like in a car loan) rather than paying a lump sum at the end. You can use the back-of-envelope method as I showed in the post, or use a financial calculator or the RATE function in a spreadsheet program. If you have Microsoft Excel, you enter:
and you get 7.5%. The formula says you make 24 monthly payments of $45 each on a $1,000 loan and then you multiply the monthly rate by 12 to get the annual rate.
Denver Todd says
Somewhere lost in your essay is the fact that the retailer will not get his full $1,000 from the financing company when the deal closes. In order to make it free to the buyer, the retailer takes a discount from the financer, maybe $850 for the $1,000 sale.
Denver Todd says
BTW, isn’t GE big in the consumer finance business?
Harry Sit says
@Denver Todd – Yes it is, through its GE Money unit.
I want to know where Nick can find $2000 braces. I have twins and the lowest quote I can find is $5500 each, and I had to negotiate for that.