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Beware the Monthly Math Trap

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Marketers are very very clever. Ever notice that banks advertise their loans in APR (annual percentage rate) while they advertise their CDs in APY (annual percentage yield)? They are slightly different calculations but an APY is always greater than an APR, so they know to advertise using the right one (lower for loans, higher for interest) to tap into your psychology.

The same is true about something I call “monthly math.” Monthly math refers to the marketing tactic of taking a large purchase and breaking it up into more bite-sized monthly payments. It’s why shopping channels like QVC always break down a large payment into “three installments of …” $200 is a lot, but four payments of $50 seems like less. It makes the purchase seem more manageable.

Most people budget by the month because it’s convenient. Perhaps you’re paid on a monthly basis, perhaps you’re not, but you probably use a monthly budget because a weekly one would start to get cumbersome (it might make sense to start weekly, but once you get in a rhythm you’d likely move to monthly).

So we’re now OK with breaking up a large purchase into several small ones and we’re also OK paying monthly.

We are conditioned into this thinking for a variety of reasons. First, if you have a car loan or a mortgage, you pay monthly. It’s usually unreasonable to expect you to be able to buy a car or house outright (certainly a house), so we are OK with paying monthly on a purchase of that size. We also understand that when you borrow money, you should pay some interest to the lender.

Now we’re OK with paying interest, along with breaking up a large purchase into many small ones (even though you take the purchase immediately), and we are OK with writing a check monthly. Up until now, everything made sense – but here’s where the marketers get clever.

Taking a $200 purchase and charging someone $50 four times makes sense, we can do four times fifty to arrive at $200. But what if we told you that you could:

  • Pay $200 up front.
  • Pay $54 over the next four months.

$4 extra a month to pay over the next four months? Does that sound reasonable? $4 isn’t all that much is it?

It’s 8%. It’s not as egregious as a credit card charging you 15% or 29.99% over several years but 8% is a pricey loan today (CD rates are about 1%). $4 doesn’t sound bad. Four months to pay doesn’t sound bad. But when you do the math, 8% is not good.

But this alone is not terribly dangerous. Where it gets dangerous is when you’re with a real estate agent and he tells you that you only need to pay a few more dollars a month to get $1,000 more in house. A $300,000 house after a $60,000 downpayment will cost you $1,129 a month on a 3.875% 30-year fixed mortgage. For less than $50 more a month, you can buy $10,000 more house (payment on that is $1,176 per month). $50 extra a month to get $10,000 more house? Sounds like a fantastic deal… except the $50 extra is for every month for the next thirty years. Simple math tells you that, in total, you’ll pay $18,000 more over the thirty years because you’re paying an extra $50 a month.

This is the slippery path that the monthly math trap takes you. Just be aware of it. :)

{ 11 comments, please add your thoughts now! }

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11 Responses to “Beware the Monthly Math Trap”

  1. Jim,
    Doesn’t this pretty much boil down to don’t-spend-more-than-you-make? I suppose it’s different for a 30-year mortgage, but for those short-term QVC purchases, if you can’t pay the amount in full simply don’t buy it.

  2. Einstein says:

    Hmm, actually it’s a lot worse than it looks!

    If you pay a total of $16 in “interest” or “fees” over the four month period, you pay an effective rate of 24% per year for a full year of borrowing.

    You would actually be better off to pay for the particular purchase with any average credit card.

  3. ImpulseSave says:

    A mortgage and a simple QVC purchase are quite different, but the math is the same and I appreciate this post very much, Bargaineer! Another big culprit is the furniture and appliance commercials that tell you “pay nothing down and no interest for 24 months!” Sounds like a great deal, except when you can’t pay it off in two years and you get slapped with a huge interest rate and out of control payments. Some purchases are worth the small installments, but I agree with Jim: if you can’t pay it off, don’t bother! You can do a lot more with four payments of $50 than get the most fashionable purse of the season!

  4. Anytime you pay interest, you pay more than you should and you end up poorer. I teach participants in my “Celebrating Financial Freedom” course to beware the lure of the marketer and never pay with credit.

    However, I won’t bust you too badly over a mortgage, as long as it’s a very sensible one (15 yr. fixed, 20% down, no more than 25% take home pay).

    Anything else you can pay cash for, yes, even cars, by using that age old technique called saving.

    • Matt says:

      That is some great advice, I am in college now and working part time, fortunately for me my parents realize the importance of saving and are letting me use a car until I have enough money to buy one with no money borrowed.

  5. Courtney says:

    I thought the difference between APR and APY had to do with interest compounding? Hence mortgages/loans report APR because you pay the monthly interest and some of the principle, while savings/CDs report APY because you earn and accumulate interest that compounds.

  6. Andrew says:

    “They are slightly different calculations but an APR is always greater than an APY”

    Other way around?

  7. I don’t think you should ever buy non-appreciating assets with credit. I’m ok with going into debt for houses/businesses because there is the possibility of return.

    But for things like wedding rings and cars, you should save up and pay cash.

  8. Shirley says:

    Great article, Jim, and it’s explained in an ‘easy to see’ way that my grandsons will understand. I will print this and pass it on.

  9. Good food for thought! Thanks, Jim, for the “big picture” snapshot. Sometimes it’s hard to stepback when looking at the monthly numbers.

    Thanks again for a great guest post! I was honored to have your article published today.

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