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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.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s most recent book, The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.

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