How to Evaluate Free Financing Ads

Flip through the ads in the newspapers and you will find offers for attractive financing of purchases of high-ticker consumer items. The offer usually states there is no-interest for a period of one year to three years. The offers are most likely to cover purchases of electronics (such as big screen televisions) and furniture.

Are these deals as attractive as they seem, and how do retailers make a profit under these terms?

The key, of course, is to examine the details of an offer to determine if it is a good deal. There are different versions of these offers. Let’s look at a couple standard offers.

The most common offers are “no payments for XX months” or “no interest for XX months.” Those sound pretty good. There are potential traps in these deals.

In many cases, the retailer comes out ahead by charging more for the item and focusing attention on the consumer’s ability to walk out the door with an item without initially parting with any cash. A customer who is not flush with cash or available credit will focus more on that feature than on comparison shopping for the price of the item.

Perhaps more important is the fine print. If the payments are not made in full or on time, then retroactive, compounded interest at high rates kicks in. The interest rates often equal or exceed standard credit card rates. There also are late fees if payments are not made on time.

Let’s look at a recent no-interest deal from a popular retailer. The offer for a big screen plasma TV was to pay no interest for three years. The buyer would pay only 1% of the principal each month, or $10, whichever is higher. The full purchase price was due by the 36 month date.

If the buyer pays the entire purchase price within 36 months, it is a good deal. There really is no interest charged on the purchase; it is a no-interest loan for up to three years.

But things change dramatically if the entire balance is not paid in full within 36 months, or monthly minimum payments are missed. The buyer needs to be aware that the minimum payment schedule in the loan agreement will not pay the purchase price within 36 months. The consumer has to be proactive enough to know this and to make sure he pays the full purchase price on time.

If the full price is not paid by the 36-month deadline, accrued interest for the entire three years kicks in. The interest on the unpaid balance accrues at very high rates, of which the buyer has a choice. A fixed rate loan might be the prime rate plus about 14 percentage points, and a variable rate might be prime plus 17 or so. Under either plan, the buyer would be paying interest at 22% and higher.

The bottom line for these deals is that they can be attractive to the buyer who has the cash or is sure of having it before the no-interest period ends. The buyer also needs to be organized enough to ensure that the minimum principal payments are made on time and that the full balance is paid before the deadline – without relying on prompting from the seller. Otherwise, the cost of the item will be quite steep. In effect, savvy, organized customers with cash are being subsidized by buyers who won’t make their payments on time and will end up paying the interest. Of course, it is important to compare prices of the products and not just the financing terms. To some extent the retail price probably is being padded to subsidize the interest rate deal.