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Should You Take That 0% Financing Offer?

You want to make a big ticket purchase, you’ve just been offered as 12 month same as cash financing offer (a nicer looking term than a 0% interest rate for 12 months), and you’re not sure if you should take it. First things first, good move taking a breather and analyzing the offer, despite how good it looks, because very often things aren’t as simple as they seem and a 0% offer always sounds wonderful right? How good of a deal this is depends on what your plans are for the next 18 months.

Do you plan on buying a home in the next 18 months? If the answer is no, take the offer.

If the answer is yes… here’s some downstream effect math for you.

What You Save/Earn

By taking this offer, you can potentially earn a little under 5% (minus taxes) on the value of the purchase by putting the purchase price into an online savings account [3]. Let’s say it’s a $2,000 television; by putting it into a high yield online savings account you will get approximately $100 in interest before taxes (the $2k will slowly diminish as you make minimum payments, so $100 is the maximum) which, given a 25% tax bracket, works out to be $75. A $10,000 home renovation job on 0% financing is an interest win of $375.

You also have to consider the effect of not using a credit card, which generally should get you 1%; so you’re real net win minus opportunity cost is only $275 on that $10,000 job (you don’t tax the 1% cashback but you do tax the 5% interest).

What You Risk

The risk is in your credit score, which will be negatively affected by your new line of credit because it represents one additional inquiry, an increase in utilization (amount borrowing divided by sum amount of credit lines), and another open account. How bad of a drop can this be? There’s no set formula but looking at some empirical evidence is the closest we can get to guessing.

Cap at Stop Buying Crap does credit card arbitrage [4] and has tracked his FICO score [5] throughout this process, giving us great empirical data to do an analysis. In October 2004, he took out a 0% balance transfer for over $7,000 which resulted in his score dropping from 709 to 667. When he paid it off six months later, his score improved. It’s difficult to say for sure whether the entire drop could be attributed to his new line of credit but I think it’s useful to simply assume that to be the case. Cap explains what happens each month but never says that’s all that happens each month.

Now, let’s look at typical interest rates on mortgages [6] (it’s dated March 2007 but the relative rates should be useful enough for our purposes, scroll down to the table) and we’ll see that a score of 709 would’ve gotten you a rate of 6.002% whereas a score of 667 barely snuck you in with a rate of 6.286%. (we have to assume the uniform rate for that block but we all can agree that a 660 won’t get the same terms as a 699) So, how much does that 0.286% matter?

Over a 30 year fixed mortgage on $100,000, the 0.284% difference will result in an additional $6,618.08 in interest. Increase the mortgage to $200,000 and the difference is $13,236.58. Sort of makes that few hundred bucks you earn in interest seem kind of paltry doesn’t it?

So, the next time you get a 0% financing offer, think about the downstream effects before pulling the trigger.