Wednesday, June 18, 2008

0% credit card instalment

I am sure you have encountered hire purchase plans when you go down to big stores like Harvey Norman, Courts, Best Denki, etc. Basically the stores allow you to pay by instalment basis when you purchase electronic or furniture items from them using credit cards.

The attractive thing is these hire purchase plans are marketed at 0% interest. But only God knows how much extra they have added to the selling price to compensate for the hire purchase payment.

The other group of people who prefers to be debt free would argue that you can get the same items cheaper when you go down to neighbourhood shops by making full cash payment. I would agree with that.

But as a savvy individual, I like to apply the concept of Time Value of Money (TVM). If I have the incentives to hold the cash in hands, why should I make full payment even if I have the money? By paying instalment, I can always put the remaining cash in some investments to generate me an income.

Therefore if you were to apply the TVM concept, the present value of all future instalment payments made can become cheaper than you pay in cash.

For example if you are given options to buy an item at $6000 in cash or pay in twelve monthly payments of $500, which option is cheaper? It is a no brainer that the latter is attractive. Even the money you put in savings bank can generate you some interest.

Now for example an item to pay in cash costs $6800. If you choose a 36 months instalment plan, you need to pay $200 monthly. So which option is cheaper in this case? To be exact, it all depends on the Internal Rate of Return (IRR) that you can achieve with the cash you hold in hands. The higher the IRR, the lower is the actual cost if you pay by instalment. Let me show how you can calculate the actual cost and compare the two options.

For simplicity sake, I will choose an IRR of 2.84% per annum because that is the current yield of a risk free SGS bond maturing in five years. You can be more conservative or aggressive in your calculation by choosing a different IRR.

Excel calculation for installment plan
Assuming you purchase the item in the beginning of the month and make the first payment at the end of the same month, the present value of all future payments turns out to be about $6900. It is expensive by $100 if you pay by instalment.

Don’t forget if you buy from the bigger stores, you are may be entitled to an extended warranty coverage on your product which the smaller stores won’t be able to offer. And also do consider the benefits of rewards or points awarded when you transact using credit cards. Therefore you need to weigh the pros and cons to decide which option is better.

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