Did you ever wonder why that Zero-percent interest on smartphone, electronics and even watches are so popular? Does this make business sense?
We have received several questions asking how the concept of interest expense is similar to a discount. In a zero-coupon bond, where the concept of discount is most common, companies receive less than what they borrow but are required to pay back the full amount. For example, if the company borrowed $100,000, with a 10% discount rate, they receive only $90,000. The full amount, however, must be paid in full by the company which is $100,000.
In a nutshell, both are similarly treated as they make you pay more than what you originally borrowed. This is all you need to know regarding interest and discount.
This same concept is what we are going to use bust the myth of the Zero-percent interest used in many of the installment plans present in buying many consumer goods.
Many of the zero-percent interest schemes are designed to make people feel the product is more affordable. After all, we are talking of little cash-out at a point in time rather than a one-time big time initial cash-out. Imagine an iPhone which you can buy for $600, for 6 months, thereby making your cash out only $100 per month. In most cases, sellers will offer a much lower price, at a discount, if you can pay in cash at the moment of purchase. So in this example, sellers can offer, say 10% discount, if you can pay in cash to drag the cost to $540.
What most fail to examine, is that most of these schemes already have an imputed interest. Remember that the basic idea of interest is that you pay more than what you currently get. In our example, the current price or the price at the time of purchase is only $540. So by deferring it to 6 months, it cost you more than the price at the time of purchase. This is now similar to interest. Some schemes, instead of discount, would choose to charge “processing fees” for the installment. This is likewise interest as it is an “additional” to the original price.
As such, the zero-percent interest scheme on those cases is not actually zero. Whether through cash discounts or through processing fees, if you actually paid more than what you can get at the current market/purchase price, then it doesn’t matter what terminology the seller used; it’s plain old interest.
Does this mean that the zero-percent interest schemes are no good and that we should always stay clear away from them?
The answer is not all the time. Here are a few instances where the zero-percent interest installment schemes clearly work:
> When the interest on borrowing on an equal amount of loan is higher than the discount rate.
Take the case above. The discount rate, on the buyer’s perspective is computed as “$60/$540” or 11.11% (semi-annual basis). Why did we take $540 as the denominator? Because it is the current price and foregoing it incurs $60. From our perspective, the discount is taken from the point of view of the current price. Thus, if the cost of borrowing exceeds 11.11% (semi-annual basis), taking the installment scheme is advantageous.
> When there are no cash discounts being offered at all.
In some cases, the zero-percent installment scheme is used as a selling strategy of companies. This means that they believe that with that scheme in place, more people will be willing to buy the product. For these cases, it is possible that the cash price and deferred price is the same. Clearly, one can take advantage of this scheme using the principle of time value of money where deferral of cash outflows are favored.