"Zero-percent" financing isn't zero interest, it's prepaid
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
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.
from the government
and I'm here to help you
Federal Trade Commission is responsible for enforcing Truth-in-Lending:
FTC, Bureau of Consumer Protection
600 Pennsylvania Ave, NW
Washington, D.C. 20580
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
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
APRs are nominal rates, not true rates.
Only true rates (APYs) are comparable.
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.
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.
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]
- The vehicle can be purchased for cash, for $18,000
- The vehicle can be financed, at $21,000 (higher price)
- The term offered is 2 years (24 months)
- The downpayment is zero ("nothing down")
- 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