Are 0% interest Loans Really Free Money?

by Adam on March 8, 2010

Welcome Carnival of Personal Finance – Tour of Ireland Edition readers. I’m thrilled that this post was selected as the top Editor’s Pick.

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Free loan

 

There are many different types of loans: personal loans; payday loans; mortgages….they all have different interest rates -the cost of borrowing.

But wouldn’t it be amazing if all loans were set at 0% interest?

That’s right. ‘Free’ money.

It would mean that loans wouldn’t cost you anything. In fact with inflation the loan value would decrease in real terms because £1 of debt would soon be worth 90p, then 80p and so on.

Sound good? It’s certainly one of the benefits of student loans.

However in most cases a 0% interest rate is not amazing. It makes debt more tempting. And in the case of consumer debt, buying ‘stuff’, succumbing to that temptation, would make growing your pennies very hard.

I’m sure you’ll all seen 0% loans advertised on certain products to make them more tempting:

“Double discounts, 3 years interest free credit and nothing to pay for the first year”

So why not take advantage of free money?

Even though the cost of borrowing is free, you are still ‘consuming’ the product: using its value in exchange for the promise that you will pay for it in the future. For companies selling the product it makes sense to offer such financing deals because, even though you are not paying for the product in full, it encourages you to take action and buy the product when you might otherwise have not, allowing them to add your flow of money to their revenue stream.

Of course this doesn’t mean that you shouldn’t ‘consume’. Spending isn’t bad in itself. In fact, it’s great, and useful, and, to be blunt, essential. Rather I’m encouraging you to spend your money more consciously.

I want you to understand that buying things with debt, even 0% interest rate debt does interesting things to how you perceive the purchase: you may even feel smug that you have somehow got away with using someone else’s money for free; That it’s ok because the monthly payments are really low. But remember the obvious point: You still have spent the money: Pennies that you may not have; pennies that you may need to pay back if your income unexpectedly drops and you can’t afford any of the payments.

 

Be smart, don’t outsmart

In your 20s and 30s rather than ‘outsmarting’ the banks and finance companies by getting to enjoy spending ‘their’ money for free, you really should simply be saving more. Not because saving is fun by itself but because any money you channel into savings and investments has the potential to grow exponentially and have a massive impact in the future. If you have taken out loans, even 0% ones, the payment is going to be make saving more difficult as you now have more outgoings each month.

Should I pay off my student loans then?

For the purposes of this post, UK Student loan debt falls outside my demonization of debt, because it doesn’t have risk attached to it (if if you lose your income you are under no obligation to keep paying on your debt). As the only debt that I have, however, I can certainly attest to the way that even an interest-free student loan debt changes the way you feel about spending:

Spending a penny without the  pain, flushing money down the drain?

When I went to university I did what almost every student does, and opted for the maximum loan possible. I then spent almost the entirety of my student loan each semester on living in the best student accommodation available. It was great. My part-time job and summer jobs paid for my living expenses and my parents and a singing scholarship covered the tuition. I loved my comfortably sized room and the 24 hour security. I also met some great people, including very generous international students who allowed me to see some of the corners of the world for free

Although this spending was hardly wreckless, looking back the cost of living was much larger than it could have been.

cautionBecause the student loan would make it cost ‘nothing’ to access the money I never considered the option of taking less than the maximum amount of student loan. And because I had not worked for the money I could spend it without any feeling of pain. It wasn’t real to me. It was just a form that I could tick and money would appear in my account.

That’s the problem with 0% loans –It’s too easy to rationalise them, because they are free. But there are not really free if it allows you to buy something you wouldn’t have bought otherwise. Or it means that you then can’t afford to invest in the market, where over the long term gains of over 7% can be achieved.

By taking away the cost of carrying debt, a 0% interest rate might seem great at first but it takes away the financial incentive to be debt free, an important step if you are to keep your lifestyle down and make an impact with your savings goals: the goals that ultimately can define your future.

 

This is a Magical Penny post in the Debt series making sure that you understand the implications and to prepare you for investing. Don’t miss a post: sign up for free updates.

 

 

Further reading:

A cute story of compounding @Financial Tales

Lifestyle inflation @Four Pillars

 

 

Before you comment that if all loans were 0% you could leverage money in the markets I’d like to add a caveat that the 0% loans would only apply to consumer goods…Hey! My imaginary scenario, my rules! )

{ 6 comments… read them below or add one }

Rightly Knightly

You miss the obvious arguement that any savings made on 0% loans would be inflationary only.

Whereas if you put the money in a savings account you will get above interest %.

The difference between the two would be additional cash.

But, you also ignore that if a purchase is absolutely necessary and 0% loan is on offer sometimes it can be the better option.

I do like your admission:

‘Because the student loan would make it cost ‘nothing’ to access the money I never considered the option of taking less than the maximum amount of student loan. And because I had not worked for the money I could spend it without any feeling of pain. It wasn’t real to me. It was just a form that I could tick and money would appear in my account.’

Another arguement in my book against the loan in its current state. You’re too positive to it!

Reply

Adam

Hi Rightly Knightly:
My views on higher education and student loans certainly are more positive than yours although I’m certain we both developed our views as a result of very different university experiences. :)

Thanks for commenting though: just as an aside my disclaimer about using 0% for arbitrage was meant to include savings accounts too.

Reply

Jonas

Back in 1999 or 2000, I took 0% no-fee cash advances against my Bank of America credit card.

I took that money and let it earn on the money market, and then repaid it when the 0% period ran out.

By then they had sent me another offer, and raised my available credit, so I turned around and did the process again.

Eventually the market changed and the offers stopped coming. By the end of it I had earned maybe $400 before taxes.

The only ill effect I noticed was a hit to my credit score from the high utilization, which didn’t really affect me at the time. It bounced back in about 6 months after I ended the scheme.

Reply

Adam

@Jonas, this kind of thing *can* work but are increasingly rare and if you make any mistake, missing a payment etc, any benefit is lost. Seems like a lot of work and increased financial complication for the sake of $400.

Reply

Online payday lenders

Zero-interest rate auto loans are also becoming popular attractive, due to the rising interest rates on other lenders’ car loans. The appeal of zero interest auto loans is in all the money that you will save.

Reply

1 Hr Payday Loans

It is good to always save some money out of your incomes. It helps a lot during situations when you have any urgent need of cash. Savings will help you a lot in future.

Reply

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