Well, we’re in the stretch of time between Thanksgiving and Christmas, and most folks are buying gifts for family, friends, coworkers, colleagues, and pets. Others are filling their homes with new furniture or electronics to entertain those relatives from far-flung corners of the globe. These days, it’s hard to find a store that doesn’t offer (or doesn’t partner with another company that offers) consumer financing to fund these purchases. You’ve surely heard the commercials on TV or radio—the pitch typically goes something like this: “Come enjoy interest-free financing for six months on qualifying purchases over $1,000.” It’s effective because, for some shoppers, it is too tempting to forego; they may not be able to pay for the goods any other way.
At this point, I feel compelled to remind everyone these offers are basically loans. By calling the product “financing” instead of “a loan”, the company has shed the connotations associated with taking on debt. There are many ways companies advertise these offers, such as:
- No payments for 6 months
- Buy now, pay later
- 90 days same as cash
- Defer payments for 3 months
There are two main types of consumer financing—one is interest-free financing, and the other is deferred payments. They operate differently, and below is a quick explanation of how each works.
Interest-free financing allows the consumer to make payments with no interest accrued during a given period, assuming the loan is paid in full and paid on time. This means the buyer pays 0% interest and spreads payments across a longer period of time instead of paying in full, up front. If the balance is paid in full by the expiration date of the offer, the buyer does not have to pay any interest. However, if the balance is not paid in full by that date, interest is accrued on the principal outstanding. Typically, the interest is accrued back to the date of purchase. To illustrate the difference between these scenarios, here are two examples built around the purchase of a $1,500 TV with interest-free financing for 6 months:
- To ensure you truly pay no interest on this purchase, you make 6 monthly payments of $250 and pay the loan in full by the expiration of the offer at the 6th month. No interest accrues on this offer, and you pay $1,500 for a $1,500 TV.
- Instead of being financially prudent, you do not pay down the loan by the expiration date of the offer. At the 6th month, you still owe $1,000 on the TV. The interest rate goes from 0% to 15%; you now owe $1,075. When the statement arrives, you are motivated to start paying down the loan but will have to stretch the payments across 12 months due to other cash flow challenges. Once the loan is paid off, you pay $1,646 for a $1,500 TV. The extra $146 is made of $75 of accrued interest on the unpaid $1,000 at the 6th month, plus 15% interest over the next 12 months totaling $71, assuming 12 equal monthly payments.
A deferred payments arrangement is a bit different than interest-free financing. This means there is a period of time where you are not required to make any payments at all; however, interest is still accruing during this time. Let’s say you bought the same $1,500 TV above under a deferred payment arrangement that expires in 6 months. At the 6th month, instead of owing $1,500 you now owe $1,613 (or 15% interest accrued for 6 months on $1,500). From there, the interest continues to accrue until the loan is paid in full. If you make equal payments across 12 months and pay the loan in full, you pay $1,719 for a $1,500 TV. The extra $219 is made of $113 of accrued interest on the unpaid $1,500 balance at the 6th month, plus 15% interest over the next 12 months totaling $106.
Even though these loans are camouflaged as financing, they still come with the same strings attached that debt has. In the vast majority of cases, the company will check your credit report and/or credit score prior to granting you financing to determine if you qualify for the offer in the first place. What this means to you, the consumer, is there will now be a hard inquiry on your credit report. Hard inquiries typically stay on your credit report for 2 years. A single hard inquiry could lower your credit score by 5 to 10 points, depending on other factors in your report. By itself, that is not a big deal, but if you rely on this type of financing on a regular basis, your credit score could be reduced by 50 points or more. And if you are not approved, not only do you have to forego or find alternative means to make the purchase, but you’ll have to live with the hard inquiry for 2 years. It’s the gift that keeps on giving (or keeps on taking, depending on your perspective)!
If approved, this will create a new account in your credit report, assuming the company offering financing is a reporting entity (almost all of them are). This new account has an age of 0 in your credit report, which brings down the average age of your accounts—this is not in your favor when it comes to calculating a credit score. The older your open accounts are, the better your credit score will be!
As covered above, these offers can be structured differently, depending on the company offering the financing and your particular qualifications. But here’s a secret: the requirements to qualify are typically low because the companies offering financing want you to pay them interest. They wouldn’t offer these deals if they didn’t make any money! So, let’s say you make it to the expiration of interest-free financing or deferred payments and still have a balance on the loan. This would likely trigger minimum payments. If you miss any of the minimum payments (just like minimum payments on your credit card), it will become a ding on your credit report that results in your credit score being lowered. It falls under the payment history section of your credit score, which is high impact. It’s important not to miss any payments!
Consumer financing is a different animal that a home mortgage or vehicle loan. Typically, consumer financing is extended for relatively low-value items, so there’s not much in the way of collateral against the loan. These companies will not spend the extra money to come out and repossess a $1,500 TV like they would a $25,000 vehicle. Couple this with a high default rate, and you have a recipe for a high interest rate. You’ll note in the example above, I used a 15% interest rate in the calculation. It’s not uncommon for rates to go from 0% to 15-20% or even higher once the period of zero interest or payment deferral expires. And this is where the companies make big money—accruing mega interest on unpaid balances.
In summary, I encourage everyone to avoid consumer financing. These arrangements are not setup for your benefit; on the contrary, they are setup to make money for financing companies. In my mind, consumer financing should be a last resort—perhaps even behind paying for a purchase with a credit card and not paying off the balance right away!