When you borrow money, more often than not there is some sort of fee associated with that; generally that fee comes in the form of interest over the term you have borrowed for. However, once in a blue moon, you can receive 0% APR (annual percentage rate) for a limited time on things.
Sounds amazing, right?
You get to have an item or items for a certain amount of time and you don’t have to pay anything at all towards it during that limited time. You can find interest-free financing in various places. There are some credit cards that offer 0% APR during intro periods, furniture stores often entice people with 0% APR and even some car dealerships offer 0% APR for the first year.
Interest free financing sounds too good to be true… and that’s because, many times it is.
I want to start by saying interest-free financing is not all bad, obviously. Let’s work through a couple of examples where we will ignore the time value of money to see the upside and downside of interest-free financing.
Scenario 1: You are furniture shopping and find a couch you love; it costs $3,000. The store is offering 0% APR financing for 12 months and 7% APR after that. You have $1,500 to put towards the couch right now, but you choose to take advantage of the financing opportunity and plan to save up the remaining $1,500 over the course of the next 12 months and pay it all off at once.
You had most of the money saved up, but before you pay it off your car breaks down and needs $3,000 worth of work. It takes you an additional 8 months to get the $3,000 saved up again for the couch. You pay it off in 18 months instead of the 12 months intended, resulting in interest charges of $105. Total cost = $3,105
Scenario 2: You are furniture shopping and find a couch you love; it costs $3,000. The store is offering 0% APR financing for 12 months and 7% APR after that. You have the $3,000 today, but you decide to take advantage of the interest-free financing and invest your money for a year.
You choose to put your money in a mutual fund that gives you a 5% return on your money in a year. You pay off the couch right before the interest would kick in. Total cost = $3,000 less $150 return on your money or $2,850
Scenario 3: You are furniture shopping and find this couch you love; it costs $3,000. The store is offering 0% APR financing for 12 months and 7% APR after that. You have the $3,000 today, so you charge the purchase on your credit card to get the points (3% at department stores) and pay it off as soon as the bill comes due. Total cost = $3,000 less $90 in cash back rewards or $2,910
At a quick glance, the best scenario is number two, where you receive a 5% return on your money resulting in $150 extra cash for taking advantage of the interest free financing and investing your money. The safest option, though, is scenario 3.
While I highly encourage everyone to invest at least some of their money, I do not condone taking on debt to do so because the market is risky regardless of how safe certain investments may seem. The best case is to have $6,000 and invest $3,000 of it while paying for the couch immediately with the other $3,000.
The problem with scenario 1 is that if you are struggling financially, taking advantage of things like 0% APR financing sounds good in theory, but without emergency funds or other forms of savings, assuming you can save for just this one item and not have to pay for anything else is being too optimistic. This is a classic case of living above your means.
Interest-free financing can be a great thing, but it is not for everyone. If you are financially unstable or struggle with living within your means, I highly discourage interest-free financing because if you are unable to pay off your purchase before the interest-free period ends, you then end up paying more for an item than you could have if you had simply paid it off at the time of purchase.
