This holiday season, the offer of free 0% financing is once again being aggressively pushed by retailers and credit card companies across the country, with MagnifyMoney finding over 50% of store credit cards offering promotional financing this holiday season. According to the CFPB, deferred interest purchases increased 21% from 2010 until 2013.
MagnifyMoney conducted a study of the offers being promoted in December by store credit cards of the top 100 American retailers as defined by the National Retail Federation. The results show widespread use of these potentially confusing and expensive offers.
- Deferred Interest Explained
- Stores Offering Deferred Interest During the 2015 Holidays
- Payment Hierarchy and Existing Customers
- When Using A Deferred Interest Makes Sense
- Tips For Consumers: Alternatives To Deferred Interest
- Thoughts from Our Founder: “This practice needs to stop.”
Study of Holiday 2015 store credit card offers finds predatory tactics
- 38% of the top 100 American retailers offer store credit cards, with some offering several via multiple brands.
- 52% of store credit cards this holiday are offering promotional financing to new customers. Others periodically offer financing to existing customers, hoping to snag those with balances in a payment hierarchy trap, making the prevalence even higher.
- 87% of store cards with promotional offers use deferred interest. The average interest rate on these cards, 24.8%, is nearly 2x the average credit card interest rate.
- 72% of retailers with cards charge all consumers a high interest rate, regardless of their credit score. The average interest rate for these credit cards is a shocking 25.07%.
- Dell and Zales have the worst rates for customers hit by deferred interest – up to 29.99% for Dell’s personal credit line, and 28.99% for Zales’ credit card.
The deals remain common because:
- They work well. Consumers respond to 0% marketing offers, regardless of the potential traps or the true cost.
- They are highly profitable. It is hard to lose money with interest rates this high.
- They remain perfectly legal. However, the Consumer Financial Protection Bureau has called deferred interest offers “the most glaring exception to the general post-CARD Act trend toward upfront credit card pricing.”
There is nothing more powerful than “free.” Behavioral economists and credit card executives agree that marketing a product as “free” or “0% interest” is the best way to get consumers to buy. But very few things in life are truly free, especially when they are given to you by a company whose objective is to make a profit.
While the 0% financing can be a good deal for many, it can turn out to be an incredibly expensive debt trap for people who use a deferred interest offer and do not pay their balance in full before the end of the promotional period. These consumers will be hit with a retroactive interest charge at some of the highest interest rates on the market. And with most traditional 0% credit cards avoiding deferred interest, consumers may incorrectly think store cards have the same favorable terms.
Behavioral Economics Insight:
- Dan Ariely conducted a fascinating experiment demonstrating the power of “free.” He offered two chocolates to people: a Lindt Truffle and a Hershey Kiss. Lindt cost 26 cents, and Hershey cost 1 cent. 40 percent of the people bought the Hershey Kiss. Then he reduced the cost of both items by 1 cent. Lindt became 25 cents, and Hershey became free. 90 percent of people took Hershey, even though the relative price difference remained the same. People overwhelmingly gravitate towards “free” offers!
Credit Card Management Insight
- Nick Clements marketed credit cards to consumers for nearly 15 years. He once conducted a direct mail test. One group of customers was offered 0% for 6 months. In the fine print, you would see that there was a 4% fee and a go-to interest rate of 18.99%. The other customers were offered a flat interest rate of 6% for the life of the balance. The vast majority of people took the 0% offer, even though it was more expensive than the 6% offer. As Nick commented, “if you put 0% in front of something, people take it. They think it is free and just grab it. But, unlike Ariely’s Hershey Kiss, credit card companies expect something in return. And they will get it.”
It is common for credit card issuers to offer a promotional rate (usually 0%) to encourage people to apply for a credit card or transfer a balance to it. Customers who apply for these products will be charged the promotional rate during the promotional term. At the end of the promotional period, any remaining balance will be assessed interest at the standard rate. In other words, the credit card companies are waiving interest during the promotional period.
Deferred interest offers are very different, and are very common with private label store cards. A typical deferred interest offer would be “0% interest for x months.” During the deferred interest period specified in the offer, the consumer is not required to make interest payments. If he or she pays off the balance in full during the promotional period, no interest will ever be charged. However, if the balance is not paid in full during the promotional period, interest will be retroactively charged at the standard purchase rate. It will be like the customer never had a promotional offer at all. What makes these offers even worse is that the interest rates charged on store credit cards are exceptionally high.
- According to the Federal Reserve, the average interest rate on revolving credit in the United States is 13.93%.
- According to MagnifyMoney’s analysis of the Top 100 American Retailers, the average Purchase Interest Rate on a store card with a deferred interest offer is 24.8%. That is 1.8 times the average interest rate.
Here is a simple mathematical example to show the impact of a deferred interest charge. Imagine a customer borrows $2,000 on a deferred interest offer. The standard purchase rate is 24.8%. He makes the minimum monthly payment during the promotional period. During the first 12 months, he will have “avoided” $469.61 of interest charges. In month 13, the full $469.61 would be added to his balance. At the end of his promotional period:
- His balance will have increased from the original $2,000 borrowed to $2,174 – despite making payments of $227.
- His monthly payment will increase from $17.91 in month 12 to $68.77 in month 13. This is a 2.8x increase in his payment, and has the risk of creating a payment shock.
According to a study of the top 100 American retailers conducted by MagnifyMoney, 42% of store credit cards are currently marketing deferred interest offers to new customers. Below are the details of these offers, ranked from the highest APR (worst) to the lowest:
Note: Dell does not offer a store credit card, but does offer a revolving line of credit that functions like store credit cards.
When you make a payment to your credit card company, the allocation of that payment is not straight-forward. Typically, the total customer balance is grouped into categories. For example, there is a purchase balance, which includes all purchases made. There is a cash advance balance, which includes all cash advance transactions made. And there would be a promotional balance, which would include any promotional offer. Each balance is subject to a different interest rate (the purchase rate, the cash advance rate, etc.)
The CARD Act required credit card companies to apply payments in excess of the minimum due to balances with the highest interest rate first. (There is an exemption: credit card companies can waive this requirement for deferred interest products. But they are not required to do so.) This rule is usually customer friendly, because it attacks high interest rate debt first and saves the borrower money. However, for a deferred interest offer, the payment hierarchy can become a debt trap.
Here is a simple example. A customer has:
- A $2,000 balance
- $1,500 of that balance is from purchases, at a 25% interest rate
- $500 is on a deferred interest promotional offer at 0%
- The minimum payment is $51.25, of which $31.25 is interest on the $1,500 purchase balance
When the customer makes a $51.25 payment:
- $31.25 goes towards interest
- The remaining $20 will go towards the balance with the highest interest rate. That is the purchase balance of $1,500.
- If the borrower makes a bigger payment, the increased amount would continue to go towards the purchase balance. The 0% deferred interest balance will not decrease.
In other words, the borrower would have to pay off the full $1,500 of purchase balances before he would even be able to begin paying down the $500 promotional balance. Credit card executives would call this a “shielded balance,” and it is highly likely the customer would get hit with a retroactive interest charge.
A deferred interest offer can be a good deal when used properly. It only makes sense if you can afford to pay off the entire balance (including any previous purchases) during the promotional period. If you pay off the entire balance during the promotional period, you will have been able to borrow for free.
Just remember that applying for a new store credit card will hit your credit score. A single credit inquiry will not be particularly meaningful (usually about five points). However, if you plan on applying for a mortgage or car loan in the next few months, you should avoid applying for a store card.
If you need to borrow money to make a purchase, there are significantly cheaper alternatives.
- Consider opening a new credit card with a 0% introductory purchase interest rate. In particular, you should ensure that the interest is waived, not deferred. You can find credit cards that waive interest for up to 21 months here.
- If you have already made a purchase and are worried about the expiration of the deferred interest offer, consider a balance transfer. You can find the best balance transfer offers here.
- Alternatively, you might want to consider a personal loan from a new marketplace lender. You can shop around for the best interest rate without harming your credit score here.
Nick Clements, the Co-Founder of MagnifyMoney, spent nearly 15 years in consumer banking and credit cards. Most recently, he ran the largest credit card issuer in the UK. Here are his thoughts on the practice:
Deferred interest represents one of the worst practices of the credit card industry today. I can’t believe I still see these offers in 2015. While savvy consumers are able to obtain an incredible deal, people who lack the knowledge are tricked into a complicated product that isn’t as “free” as it seems. The product advertises 0% interest. But a person can make the minimum payment and see their balance go up. Because of complicated minimum payment rules, a borrower can easily get trapped in debt without realizing how the trap has even been designed. These offers prey on people who understand them the least.
Any time you find a product or practice that makes all of its money from a very small percentage ill-informed customers, you know you have a problem. Negative amortization, balance shielding and retroactive interest charges at sky-high rates regardless of credit score are practices that belong in the 90s. Issuers who make these offers are racing against time. Either the CFPB will make rules to stop it, or the Silicon Valley marketplace lenders will create a transparent alternatives. In the short term, this deception will continue to generate big earnings. But in the long term, I expect deferred interest offers will eventually disappear. As they should.
Shame on big brands like Apple that continue to profit from this deceptive product.