Tuesday, June 12, 2007

On High-Interest Fleecing

So, in a previous post I reviewed a BusinessWeek article about how companies make money by charging really high interest rates to poor people.

One example given was a guy who bought the equivalent of an $800 computer, with bi-weekly payments over a 9 month period. He realized that at the end of 9 months he would have paid $1344.66 for it, and decided to cancel his order (unsuccessfully). The article didn't give the interest rate charged, but I (with the help of a classmate with sharp algebra skills) figured it out:

With compounding interest, we're looking at about 6% a month. I can imagine when the guy made the deal over the phone and thought "Oh, 6%, that's alright. My credit card charges me 18%," not realizing that 6% a month means he's going to pay about 100% as an annual rate.

I'm currently taking a corporate finance class that looks at firms' decision to extend credit. Usually, it's in-house credit, like your Home Depot or J.C. Penney card (unlike a Visa card). We are often given a scenario like this:
"Your firm believes that extending credit to customers will increase sales by 10%. Your bad debt expense will be about 1% of sales, and your collection costs are also about 1%. Will giving 60 days for your customers to pay, and a 2% discount if they pay within the first 5 days, add value to your company?"

You have to compare the loss of value of receiving funds within 60 days (plus the given % of people who pay early and take the 2% discount) to the gain in revenue from the 10% boost.

They don't, however, teach us about how firms market a 100% annual rate as a 6% monthly rate. They also don't mention that J.C. Penney makes more money off its in-house credit via the interest payments than it does in actual sales (according to Dave Ramsey). Extending credit is just mildly alluded to as a profit-generating tool. We had a chapter that focused on collection procedures, and at what point you make the decision to hire a collection agency. But, they don't teach us any of the unethical practices that are common in the businesses we study, and which the BusinessWeek article pointed to, and the incredible amount of consumer debt the U.S. has (about $12 trillion).

Why did I even want to figure out the guy's monthly rate?
Using the present-value analysis in class, we often determine that buying on credit can be helpful to the company. If you buy something for $10, and pay for it in 3 months, then you're better off because the $10 isn't worth as much in 3 months as it is now. Economists have a technique called "discounting," and it's when you see what you could have done with those $10 in those 3 months rather than paying. You could have invested them in a mutual fund that gives a decent rate of return, and generated value for your company while you waited to pay the $10.
I got to thinking: "Well, maybe buying on credit isn't so bad after all. If the guy buying the computer had $800, it's possible that he was making his monthly payments, investing the rest, and still came out on top." Then, I calculated the 100% annual rate. In order to come out "on top" you need an investment that's going to increase your return by more than 6% a month. Unless you dabble in highly illegal markets, you're not going to find that. 20-25% a year would be a great return.

So, it really is a game that you're likely to lose. Only in our very limited classroom models can we make a case that buying on credit (and sometimes even paying late) is worth while. Don't try it at home.

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