With Christmas rapidly approaching funds are often tight for many people as they partake in the festivities and purchase gifts for family and friends. If the cash flow becomes low there may seem like no better time to borrow money or to obtain goods on credit terms. What may surprise you is how much it costs to do so; once you enter into such an agreement you may find that the total you are paying is rather more than if you paid in cash.
In a follow up to my previous article on consumer credit I have analysed the credit terms for some typical household appliances from the big brand stores. The question which needs to be asked when you buy on credit is do you really understand what the rate of interest is that you are paying? As I will show, I do not believe that people do appreciate the true interest rate, and this is largely down to the way the stores present their hire purchase deals.
Stabroek News polled four major stores and obtained the following information for goods purchased on hire purchase via regular payments over two years:
The first thing to check is the total charge for credit, or what the difference is between the cash price and the total repayment amount. Expressing this as a percentage of the cash price less the deposit paid gives a very good indication of how much extra you are paying on hire purchase. As can be seen from the table below, it costs from between 51% and 69% more than the cash price to buy on hire purchase. What may not be so obvious is that this percentage also provides a very good approximation to the true rate of interest you are paying. The accurate calculation is somewhat involved, but the approximation can be done with a pocket calculator on the spot so should enable people to at least to get a ball park feel for the level of the interest rate they are paying.
The difference between a flat rate and APR
You may be wondering why you should go to the trouble to calculate an interest rate, when the hire purchase company quotes an interest rate and/or you know the total amount you are repaying. The thing to appreciate is that you will almost certainly not be comparing like with like if you compare different deals just by looking at the total charge for credit. For starters, the cash prices of the items might be slightly different. Second, different companies may well have different mark ups between the cash and normal prices. Finally if repayment terms and periods are different even if the quoted flat rates are the same, the actual interest charge will be different. The annual percentage rate of charge or APR wraps all of these differences up into a single figure. The deal with the lowest APR is costing you the lowest in terms of the credit which you are being given.
A simple example may illustrate the difference between a flat interest rate and an APR. Suppose I borrow $100,000 at a flat rate of 7.62% to be repaid in two equal annual instalments. Flat rates have an advantage that it is easy to calculate the total interest charge and hence the regular repayment. My total interest charge is $15,240 (2 * 7.62%* $100,000) and the annual repayment is $57,620. Now suppose I take the $100,000 I just borrowed and put it in the bank - what rate of interest would I need to earn in order to meet the loan repayments? If you thought 7.62% you would be wrong. At the end of year 1 my $100,000 has grown to $107,620. Less the first repayment of $57,620 leaves $50,000, so on first inspection all looks well since I have repaid half the loan halfway through the term. However, this $50,000 is only going to grow to $53,810 in the second year so I will be $3,810 short at that time.
This situation directly mirrors what happens when you buy on hire purchase. Since you are making the repayments, the APR or interest rate the lender is charging you is the rate which you would need to earn on the bank account if you hypothetically banked the money you had been advanced in order to meet the repayments. As you can see this rate is more than the flat rate. Using a bit of trial an error, by changing the interest rate until I just have enough money in the bank at the end of the period I reveal the actual interest rate I am paying as 10%. In fact this is a nice round figure because I actually started with it and used it to determine the flat rate of 7.62% , not the other way around.
So, armed with an APR the relative costs of different hire purchase deals stand revealed. All calculations assume repayments start one month following the date of purchase.
As you can see, these are pretty close to the approximate calculations made already.
From the example, you would expect the APR to be more than the flat rate, but without exception these APRs are more than double the flat rates. You thus might well be wondering how someone quoting a flat rate of 25% can actually end up paying an effective rate of over 70%.
The answer lies in the practice of applying the flat rate to the normal price not the cash price. This practice is designed to make the terms of credit appear more attractive. In fact in the United Kingdom the Consumer Credit Act 1974 gives the courts power to grant relief to people who have entered into what they consider unfavourable credit transactions. In its leaflet describing the process the Office of Fair Trading describes what is quoted here in Guyana as a "normal price" as a "colourable cash price" - "one that is artificially inflated to make the credit charges appear more reasonable".
Naturally the stores here present the difference between the normal and cash price as a "discount for cash" rather than the as the normal price being an additional mark-up on the cash price for those who buy on credit, but I think it is about time that the playing field is levelled, and at the very least if flat rates are quoted they should be being applied to the cash price not the normal price. Better still, the APR should be quoted, but given the size of the figures relative to current bank loan rates this may see resistance from the companies.
The final difference between the flat rates and the APR arises if the lender requires the borrower to enter into any other transactions before advancing credit, such as compulsory insurance in the event of sickness or unemployment. Both Fogarty's and Courts require this insurance, paid either as a lump sum in advance or added to the regular repayments. Using Courts as an example - using the flat rate quoted a calculation of the interest charge based on the normal price reveals weekly repayments of $2,356 yet the total repayment quoted is actually $2,385, the difference being the weekly cost of the insurance of $2,941.
It is a sobering thought to realise that even in the developed world credit is still being offered on terms which are difficult to compare. Such is the importance with which consumer credit is viewed in the United Kingdom the new legislation being proposed was even mentioned in the Queen's annual speech to Parliament. This comes after more than 30 years since the 1974 Act was passed. Perhaps it is time for consumer advocates here to take up the mantel, and lobby for legislation which will protect consumers engaged in consumer credit transactions, let them appreciate the rates of interest they are paying and let enable them to directly compare the cost of credit between different institutions.