Tuesday, April 12, 2011

Decepticons: 16% is not 0%

There’s a local TV ad for a window company. They advertise “5 year no-interest financing, or a 30% factory-direct discount.”

Targ manure! If the cash price is lower than the financed price, you’re effectively paying interest on the financing. But how much?

Suppose our windows have a “list price” of $1,000. We can either pay $700 up front, or finance $1,000. Assuming that the financing offer requires fully amortized monthly payments over the course of the loan, the monthly payments will be $1,000/60=$16.67, for something we could have bought for $700 now. We can calculate the implied effective annual interest rate in Excel:

=EFFECT(12*RATE(60, -1000/60, 700),12)

The answer is: 16.12%. That’s an astoundingly high interest rate to pay for “free” financing.

Even if there are no monthly payments, so you can sit on the money (invest it) and pay the $1,000 as a lump sum after 5 years, the implied annual interest rate is 7.39%.

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