Interest free… the gain or the pain?
It's so easy to get excited when retailers advertise "years" to pay off your purchase at no extra cost, but like anything, there's no such thing as a free lunch!
How many people have visited a retail store recently with the intention of 'window shopping', only to be enticed by a pleasant salesperson to make a purchase through an interest-free purchase program?
Whilst having 2 years interest-free to pay off a large purchase may sound too tempting to pass up, as with anything, always go back to the age-tested saying "buyer beware". In the case of interest-free it's not as simple as it sounds.
Here's a common scenario…
Tom and Mary went window-shopping and fell in love with a deluxe cream leather lounge suite. The price tag was $5,000. They hadn't planned to spend that much money.
"You can pay it off over 24 months", the salesman said, "with no interest at all added to your repayments. There's just a $20 start up charge and a $2.50 per month account keeping fee. That's all there is."
Tom and Mary thought about this for a few minutes. Tom did some high school maths in his head and replied "You're asking us to believe that we can either pay $5,000 for this lounge now, or else pay around $210 a month for 24 months and you won't charge interest?" "Correct" the salesman confirmed.
Tom was not the kind of person to look a gift horse in the mouth, but he thought the salesman must have missed something in the fine print. After all, if Tom and Mary kept the $5,000 and invested it, they would be making some extra dollars on their investment, and at the same time, enjoying a comfy new lounge.
Tom knew there had to be a downside to this deal because businesses have to make a profit.
Where was the profit to the retailer in this interest-free purchase program?
It comes from the way they set up the repayment reminder system.
In the above example, Tom and Mary would receive a bill for the minimum repayment each month, say $150. Obviously this won't fully repay the $5,000 purchase price in 24 months and that's when the real interest rate kicks in. In fact, anything up to 27% per year!
What this means is that on the outstanding balance at the end of the agreed period, the interest charge would be around $1 for every $4 of the loan amount outstanding! For instance, if you had a loan of $4000, how would you feel about paying an extra $1000 interest per year? That's just not smart buying, is it?
So, the moral of this story is…
If you intend to buy using an interest-free arrangement, check your budget and make sure you can repay the whole amount of the purchase price (and fees) before the expiry of the interest-free period. If you do this, interest will be your friend. If you don't, it will be a very expensive enemy.
Important information
The information in this article does not take into account your objectives, financial situation or needs. Therefore, before acting on the information, you should consider its appropriateness to your personal circumstances. Although this information was obtained from sources considered to be reliable, it is not guaranteed to be accurate or complete. This publication was prepared by AMP Financial Planning Pty Limited ABN 89 051208327. The information is current as at 22 November 2007 and may change over time.
