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Beware the Monthly Math Trap

Posted By Jim On 03/28/2012 @ 7:15 am In Personal Finance | 11 Comments

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 [3] 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.


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