govtwork / loans / ''Zero Percent'' financing is really prepaid interest

Copyright 2001, 2002, Joel Anderson

Auto loan "0% or $3000 off" gimmick - Zero_Pct.WK1

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"Zero-percent" financing isn't zero interest, it's prepaid interest

Ways to skin a cat

Auto companies and dealers know the value of money, they borrow it. They know that the average consumer lacks the sophistication to figure out how financing works. They attempt to recover what they've lost on price with gimmick financing. The easiest way to do this is to misrepresent the cost of money.

I'm from the government
and I'm here to help you

The Federal Trade Commission is responsible for enforcing Truth-in-Lending:

FTC, Bureau of Consumer Protection
600 Pennsylvania Ave, NW
Washington, D.C. 20580

Interest charges are disguised by including them in the (higher) price. By law (Truth-in-Lending) and logic, the difference between the cash price and the financed price is interest.

Determining monthly payments under the "zero-percent" scheme

With a nominal interest rate of zero (0%), (nominal means in name only), the payment equals the amount financed divided by the term. This simplifies calculating the monthly payment. But "zero- percent" financing isn't zero interest, it's prepaid interest. Prepaid interest leads to an unexpected and perverse effect, the larger the downpayment, the higher the true rate of interest.

A downpayment (cash or trade-in) raises the cost of "zero-percent" financing

The cost of financing is higher with a large, or larger downpayment, or more valuable trade-in. The prepaid interest, included in the higher price paid to receive the financing, is spread over a smaller loan. Perversely, the more cash down, the smaller the loan, and the higher the true interest rate.

Paying off the loan early (shortening the term)

Since the amount of interest is fixed in the higher initial price, an early payoff raises the rate. Lengthening the term would lower the rate. This is why the length of the term of so-called "zero-percent" is limited.

It the term isn't limited, then the interest included in the higher price covers the longest term available. Shorter term borrowers are paying higher rates than long term borrowers.
The perverse effect of an early payoff raising the rate is another reason to use alternative financing, financing that doesn't include prepaid interest - even if the rate on the alternative financing is the same. An early payoff of a conventional loan, shortening its term, would reduce the amount of interest paid.

Calculating the interest rate on alternative financing

You can figure it out

Below-market-rate financing is a discount on price. Many "low-rate" ads do not disclose a cash discount. Dealers know the value of below-market financing, ask them. Or compute the cash value of the financing.

APRs are nominal rates, not true rates. Only true rates (APYs) are comparable.

Determine the true rate on dealer financing, then shop for alternative financing.

A discounted cash flow analysis of dealer financing can deliver an APR (a nominal rate) and a true rate (APY). But alternative loans are quoted in APR. To compare loan rates from alternative sources, do a discounted cash flow analysis of the alternative loan's flows to find the true rate (APY). Then compare true rates.

If this seems complicated, try to remember that the banks wrote the rules to prevent easy comparisons.


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The larger the downpayment, the higher the interest rate.

In this example, "Zero down, zero-percent financing" is really 15.26% (APR), true rate 16.38% (APY).

$2500 down increases the rate to 17.60% (APR), 19.09% (APY).

Calculate the interest rate by discounted cash flow [DCF]

  1. The vehicle can be purchased for cash, for $18,000
  2. The vehicle can be financed, at $21,000 (higher price)
  3. The term offered is 2 years (24 months)
  4. The downpayment is zero ("nothing down")
  5. The interest rate is nominally* zero (0%)
                          * Nominally means in name only.

 NOTE: the first value in a DCF calc is always negative.
       If you extend the number of payments, be sure
       to included all pmts in @IRR's range.

---- No Downpayment -----    ---- w/$2500 Down --------

           APR      APY             APR      APY
Calc>    15.26    16.38           17.60    19.09
  0  -18000.00 Cash value     -15500.00 Cash value - down
  1     875.00 FinValu/mos       770.83 FinValu/mos
  2     875.00                   770.83
  3     875.00                   770.83
  4     875.00                   770.83
  5     875.00                   770.83
  6     875.00                   770.83
  7     875.00                   770.83
  8     875.00                   770.83
  9     875.00                   770.83
 10     875.00                   770.83
 11     875.00                   770.83
 12     875.00                   770.83
 13     875.00                   770.83
 14     875.00                   770.83
 15     875.00                   770.83
 16     875.00                   770.83
 17     875.00                   770.83
 18     875.00                   770.83
 19     875.00                   770.83
 20     875.00                   770.83
 21     875.00                   770.83
 22     875.00                   770.83
 23     875.00                   770.83
 24     875.00                   770.83