Earn 15%+ by Taking Advantage of Prepayment Discounts
by Michael Cave, CLU
October 1, 2004
(AgapePress) - Many people make monthly or quarterly payments when they could be earning a discount for paying in full in advance. This could be for anything from insurance premiums to tuition payments. You might be surprised at the effective rate of return you can earn by paying your entire bill up front rather than electing to pay in installments.Consider an insurance policy costing $1,000 annually or $87.50 monthly. How much does it cost to pay it in monthly installments? In absolute dollars, it's an easy calculation: twelve $87.50 payments is $1,050. The insurance company is charging you $50 for the luxury of spreading your payments out. But if you have money in your emergency savings fund that will likely not be needed over the coming year, the question becomes, "Should I withdraw enough to pay in full now and save the $50, or should I leave my savings undisturbed to earn interest?" In other words, "What does the $50 translate into as an interest rate, and how does that compare to my savings earning rate?"
At first blush, you might think paying monthly is costing you 5%, since $50 divided by $1,000 equals 5%. However, the amount you owe to the insurer declines by $87.50 with each monthly payment. Initially you owe $1,050, but by year-end you owe nothing. So, the average outstanding balance for the year as a whole is around $500, making the $50 additional charge you're incurring closer to an interest rate of 10%.
A financial calculator reveals the exact annualized interest cost for this example to be 10.8%. This is based on withdrawing $912.50 from savings to go with the $87.50 you have on hand, and assumes the 11 monthly payments are made back into your savings account. (It's important to be faithful in this regard; if you fail to deposit even one of these payments, you'll more than undo the interest rate advantage you have realized.)
So, 10.8% is what you'd be earning on your money if you could pay the $1,000 premium rather than $1,050 to go the installment route. But it gets better! Because the additional $50 must be paid with after-tax dollars, saving it is like earning 10.8% tax-free. Assuming you're in a federal tax bracket of 25%, that 10.8% is equivalent to a pre-tax return of 14.4%. If your savings is earning about 2% in a bank money market account, you can increase your yield more than seven-fold! Plus, you save the time of writing a monthly check, and the cost of an envelope and postage. In a similar vein, when I ran the numbers for a tuition plan at a private elementary school, the effective pre-tax return for paying in advance exceeded 20%.
(For insurance policies, typically you can change to an annual payment even if you're not at the policy anniversary. Ask the company how much is needed to pay to the anniversary. Send this with a request to bill you annually in the future.)
The bottom line is this: If you have enough in savings to pay annually, you'll usually gain more by saving these high-interest charges than by earning a low taxable interest rate. It emphasizes the truth of Proverbs 21:20 and 22:7.
Not sure how to develop a personal investing plan? The Sound Mind Investing newsletter can help -- go to our website to learn more. Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective.
