The True Cost Of Using Other People’s Money

The Truth in Lending Act, which has been around since 1968, introduced most Americans to the annual percentage rate, or APR, which measures the true cost of money we borrow.

But APRs can help us evaluate transactions that have nothing to do with credit cards, mortgages or other loans. Many consumers fail to realize it, but there are a lot of ways in which we pay to use money, either our own or someone else’s. Not all of these are legally defined as loans, and so not all of them require disclosure of APRs or other measures of the true cost of the money we’re using.

Insurance premiums, which are frequently paid in installments, are a good example. In his print publication The Insurance Forum, Joseph M. Belth recently examined Massachusetts Mutual Life Insurance Company’s disclosure (required by a lawsuit settlement, not the truth in lending law) of the cost of such installment payments. Insurance companies often refer to these installment plans as fractional or modal premiums. Belth gave the following example: “[…] suppose a company multiplies an annual premium of $1,000 by a ‘modal factor’ of .087 to get a monthly premium of $87. The fractional premium charges in a year would be $44 ($87 multiplied by 12, minus $1,000).” That is, by paying $87 per month for a $1,000 policy, you end up spending a total of $1,044 over the course of a year.

Many people might assume that the APR in this example is 4.4 percent, but that would be an incorrect assumption. The policyholder doesn’t get the use of the full annual premium for the full year. Instead, the policyholder has use of a smaller and smaller remaining amount each month as he or she pays down the premium. In Belth’s example, the APR would be 9.5 percent. (On the Insurance Forum website, Belth offers a calculator for fractional insurance premiums which demonstrates the principle.)

Few people think of themselves as borrowing money when they pay an insurance premium monthly instead of annually, but that is precisely what they’re doing. The same principle applies in many cases where it is ultimately cheaper to pay a lump sum rather than in several installments for a product or service. Many times the added price of an installment payment plan is described as a service charge or a convenience fee, but the name does not matter. It all comes down to the cost of using someone else’s money.

Then there are the costs we incur just to use our own money. Think of the fees you pay when you use an ATM. Generally, the fee is a fixed amount regardless of how much money you withdraw.

Suppose a certain ATM charges a $2 fee. Presuming your home bank doesn’t charge you anything more, withdrawing $400 effectively results in a one-time 0.5 percent fee. If you withdraw $40, you’ve paid a one-time 5 percent fee instead. If you withdrew all your money in such $40 increments, you would end up paying a full 5 percent of the money in your checking account to the owner of that ATM by the time you finished.

It makes sense, then, to withdraw larger sums on fewer occasions – or, better yet, to try to avoid such charges altogether, either by using only your own bank’s ATMs or by banking at an institution that reimburses ATM fees charged by other banks. Otherwise, you have effectively paid a surcharge to use your own cash.

There are those who might argue that taking out their money in large amounts would lead to that cash slipping through their fingers. If that assumption is true, then the ATM fee is the price of being undisciplined. If that’s a fee you’re willing to pay, so be it. But it’s important to think about such fees realistically.

We are living in a strange period. Banks and the U.S. Treasury are telling savers that their short-term deposits are worth practically nothing. Certain borrowers receive an offsetting benefit through historically low rates on mortgages and other debt, but other forms of credit and pseudo-credit remain expensive. The bigger the gap between what we pay for money and what we earn on our savings, the more important it is to keep a close eye on what we pay.

About Larry M. Elkin 561 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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