Opinion

Felix Salmon

The end of jam-tomorrow culture

By Felix Salmon
April 30, 2009

There’s a great discussion going on in the comments of my financial literacy post about the question which 93% of Americans got “wrong”: what’s better, paying off a $1,000 appliance at $100 a month for 12 months, or waiting a year and then paying off a $1,200 lump sum?

The “right” answer is that the lump sum option is better, since it carries a much lower effective APR, but my point of view is that in the real world someone choosing the second option isn’t going to diligently put $100 a month into an interest-bearing savings account and thereby make a bit of extra money, and instead is just going to wind up owing $1,200 in a year’s time — basically just kicking the “how do I pay for this appliance” problem down the road, and making it $200 worse.

Dsquared asks if my view isn’t “just a leetle bit patronising” and accuses me of basically saying this:

I myself would of course choose option B, but as for the poor little feckless working class, they’re not really to be trusted with money, so they’d better go for option A.

But that’s not what I’m saying at all. The point is that there’s a hidden assumption here: that option C — which is simply writing a check for $1,000 — isn’t on the table, and that the purchaser doesn’t have $1,000 to pay for an appliance. So no, I myself would not choose option B, since I would choose option C and just pay for the thing.

On the other hand, Dsquared makes the very good point that a bit of empirical evidence would be very useful here, and that having this debate in the theoretical stratosphere really helps no one:

Is there actual evidence that people who own a load of stuff on installment credit have better financial outcomes than people who have a bunch of debt?

I don’t know whether there’s evidence to that effect, but I would love to see what the evidence is, and I have to say that my intuition is that, yes, people on installment credit do have better financial outcomes than people with a lot of undifferentiated lump-sum debt. But I might be wrong.

I also got a great email from Mike, of Rortybomb fame, who points out that this question is applicable not only to the poor but also to (a certain subset of) the rich:

Keeping the logic the other way: Let’s say instead of paying, you could get paid at your job $100 a month for 12 months, or get paid $1500 at the end of the year, and the interest rate is 1% a month. Option 1 is a net present value of ~$1125. Option 2, the one time payment, is a NPV of ~$1330. (ii) is the correct answer, it is worth more.

Unless your company goes bankrupt in month 11. (ii) is also the payment all the Wall Street kids took with their ‘no payments except for the yearly bonus’ option. And we wonder why they whine about not getting bonuses – time-value told them that was the smartest choice, way smarter than getting smaller payments throughout the year! How much better off would economics/finance be if they realized that people’s value of security and consistency wasn’t a defect of their puny minds not being able to handle utility theory?

More generally, the whole credit bubble was, in effect, what happened when the world started paying huge amounts of money today for jam tomorrow. Anybody choosing the $1,200 lump-sum repayment is basically making a bet that even though they can’t afford $1,000 today, they’ll be able to afford to pay $1,200 in a year’s time. But the fact is that people who can’t afford $1,000 today generally can’t afford $1,200 one year later, which means that most people taking that option are in a sense deluding themselves. Just as bankers deluded themselves that their year-end bonuses were money in the bank.

Comments
18 comments so far | RSS Comments RSS

Doesn’t it also matter what is being purchased? If a person is in a financially fragile state – some sort of borderline poverty – and what they are buying on credit is some new clothes so they can be dressed properly for their new job, then it’s a no-brainer and even a 100% effective interest rate is worth it because the alternative is much worse – unemployment.
The story could be similar if we’re talking about a refrigerator – assuming the person’s own refrigerator broke, and going without would be a serious problem. Or a car. If yours breaks down, you probably need it to get to work in most cities in the US. Not fixing it isn’t an option, but if you don’t have the cash now, even a very high APR is better than a broken car and the no job that likely would result.
Let’s not get too caught up in thinking like investors.

Posted by Jesse Blocher | Report as abusive
 

There’s so much to talk about here.

First, a lot of the calculus here is rooted in family upbringing, life-cycle dynamics, and rational expectations based on past experience.

So my husband (like you) would pay cash upfront for the appliance or he wouldn’t get it (unless I beat him over the head enough with a frypan because the old one broke and I had to bear the brunt). Cash for cars too.

In my early years I would have done the installment plan because I was incapable of budgeting but if someone did it for me I found I could manage ok. When we started making a bit of money and had hopes of bringing in more (the economy was good, we were getting frequent raises and had no kids) we did some of the “pay next year in lump sum” thing (usually because there was 0 interest) and it worked out fine.

In other words, over our life cycle I have been capable of choosing any answer.

Today I can afford the appliance but might not have a home for much longer in which to put it, so I won’t be buying one at all. I’m not even that old, but I may be starting the cycle all over again. Fabulous. Next I’ll get acne.

By the way, your point about bankers and bonuses is not quite right since technically their bonus is supposed to depend on the overall health of the company and if it deteriorates the bonus slips away, maybe to 0. They have been conditioned to see it as a right but it wasn’t supposed to be one. Our experience with bonuses has been not to bank on one and to be thrilled with whatever we got, but then we never pulled in the seven figure sort either.

 

I fully understand why Option B is “correct”. Heck, I went to MIT so the math is not the issue at all.

Personally, I think it is very reasonable for a person to choose the monthly option.
a) It’s just how budgets are handled for many people, and the overhead of tracking this expense differently is not worth the hassle.
b) I sometimes use monthly payments to avoid the “wealth effect.” Setting aside the money for a later payment could make me appear wealthier now – and could lead me (or my spouse) to spend more.
c) If people are choosing A because their instinct is NOT to put off a big payment until later, well, at least their instinct is pointing them in a responsible direction generally speaking. I would be far more frightened if they were choosing a more expensive option just to pay in the future instead of the present. Some people should not try to get too clever – and that’s fine.

Posted by Milo | Report as abusive
 

what does “out of conference” mean?

Posted by bdbd | Report as abusive
 

I offered my young son (he was 12 then) what might be a reverse offer — I’d give him $500 at the start of the year, rather an equivalent weekly sum ($500/52) over the course of the year, with the carrot of some sort of matching payment for whatever he still had on hand at the end of the year. He declined, arguing that he was too young for all that planning stuff, and confident that he’d fritter away the $500 pretty quickly and then be left with empty pockets for much of the year.

Posted by bdbd | Report as abusive
 

This question is equivalent to another dilemma. Should you have all your estimated taxes withhold from you paycheck every month, or you can put them in your savings and pay at the end of the year. The rational answer is obvious, but the optimal behavioral decision is not. Introducing a firm bound on your available decision space, i.e. your available money, leads–in my opinion–to better overall performance.

Posted by dbar | Report as abusive
 

I happen to have access to credit report data at two points in time, so I run a very simplistic test on this. I regressed:

Future Credit Score ~ Credit Score + Total Credit Limit + Installment Limit/Total Limit + Revolving Limit/Total Limit

Where FCS is at t+1 and all the other variables are at t.

While there are problems here, mainly that FCS does not equate to ‘good financial outcomes’. Other problems include the use of limits instead of balances (but hey that is the data I have).

In any event, the results are counter to what Felix suggested. The only negative coefficient of the lot (which reduces future credit score) is the ratio of installment to total credit limit. Meaning that those who have higher installment limits tend to have lower credit scores than others. While the ratio for revolving to total is positive.

Again, there are many problems here including supply/demand considerations – but in absence of a more complete study it is illustrative.

Posted by nomad5 | Report as abusive
 

I think the most interesting thing here is the choice of rates and payment amounts in these examples. When we’re as close to the zero bound as we are now, when even retail savings accounts pay under 2% in most cases, the choice of upfront versus serial payments becomes nearly moot in the short term. To a consumer with no debt burden, the only real opportunity cost is that the money could have been earning a few measly points of interest.

The real question in my mind then is why the differentials in NPV for different payment options exist and how they are sized. In the original example, there is a premium in the NPV of 12 $100 monthly payments vis-à-vis the NPV of one $1200 payment (at a 2% discount rate, it’s about $10.75). Does that premium exactly capture the “convenience yield” in the problem? That is, is the value of not having to do one’s own budgeting worth exactly $10.75 to the average consumer who chooses the payment plan? Would the terms change in a different interest rate environment so as to keep a constant convenience fee? (They should, but they probably don’t). Financial literary could arguably be improved if this calculus were not “hidden” but were made explicit in the pricing.

Financial theory would suggest that the difference is well explained by the convenience, as people have suggested in the comments, and therefore whether or not the one payment plan or the other is advantageous has to do with one’s personal discount rates (which might be drastically different from market interest rates) and whether or not the convenience is correctly priced in the offer.

Thus in Mike’s example, the difference in NPV of a regular salary versus a bonus should be explained by the default risk of the company. The theoretical argument would be that while discounting the bonus payment at the 12% annualized interest rate gives you a higher NPV than that of the regular salary, you should in fact be discounting at 12 plus some default risk premium such that the current NPV is equal to that of the regular salary (or potentially so that the difference is composed of default risk minus a convenience premium to the salaryman who has an easier time paying his monthly bills). Mike’s example assumes we should discount the $1500 bonus at about 28.7% (1500 e^-x = 1125), which suggests that if we ignore the convenience lost and costs of financing monthly bills while waiting for the bonus, the recipient requires an additional 16.7% return to compensate for the risk of not getting the payment.

So to finally come to a point: the problem isn’t with finance, it’s with how it’s used. Mike is spot on. The existing theory neatly points out the very real risk/reward tradeoff in deferring compensation or using a payment plan. The problem is when financial planners, quiz writers, and investors ignore the implicit risk premia that are well understood on an intuitive level by individual decision-makers.

Posted by Jacob | Report as abusive
 

congrats felix, you made the who’s who of finance bloggers today

http://thereformedbroker.com/2009/04/30/ whos-who-of-financial-bloggers/

Posted by hortense | Report as abusive
 

OMG – Jacob, thank you for pointing out the “convenience yield” angle on this and elaborating.

I think finance has a serious problem with this, speaking as a finance theory guy. In most other situation, be it how much you’d pay for a coin flip, how much you pay for insurance, the premium over interest on a bond or a CDS, we assume that people aren’t idiots but instead take that information as given and use it to find an ‘implied’ risk-premium.

Why can’t the finance professors think that the 15% APR extra they are willing to pay functions as that same type of risk-aversion or the price of the convenience yield of budgeting (or impulse control)?

 

Of course the major assumption behind these questions is that you have access to cheap and convenient financial services in the first place. But where does one go to find a bank willing to pay interest on 12 deposits of $100 spaced over the course of a year? Certainly not in the less wealthy neighborhoods, especially since deregulation.

Also, if 93% of respondents answered the question incorrectly, we are not talking about a “feckless working class.”

Finally, regarding empirical evidence, you might want to check out papers by Paige Marta Skiba (Vanderbilt Law) and Jeremy Tobacman (Wharton). Not 100% on point, but in the neighborhood.

Posted by Mike | Report as abusive
 

Mike, an excellent question. Some of my professors have done just that (I certainly didn’t come up with it by myself), but all too many do not. It does seem like there aren’t very many prominent people championing this view out there…maybe Paul Wilmott? I think this goes hand in hand with the debate over complete markets and all that nonsense; the discipline needs to do a better job acknowledging risk-aversion, impulse control, etc. as you say.

Posted by Jacob | Report as abusive
 

John Caskey at Swarthmore College has also done research on financial services and choices available to lower income folks. http://www.swarthmore.edu/x1082.xml

Posted by bdbd | Report as abusive
 

“Dsquared asks if my view isn’t “just a leetle bit patronising” and accuses me of basically saying this:

‘I myself would of course choose option B, but as for the poor little feckless working class, they’re not really to be trusted with money, so they’d better go for option A.”

My view on this is, most people I know who are not ‘money people’ agree with the sentiment that the payment plan is more ‘advantageous’ because it is harder to screw up through failure of discipline or wishful thinking (as in, ‘I don’t need to save today, I’ll double tomorrow’).

I wanted to pay down my mortgage faster, and I could have just payed ahead on my 30 year mortgage, but instead I refi’d into a 10 year so that I didn’t have to ‘make the choice’ every month.

It’s a way to leverage a moment of good intentions into long term concrete discipline.

Posted by Chuck | Report as abusive
 

Great comments everyone. Cheers to all of you for illuminating the day. I’d just like to add that I tend to go with payments on large ticket items that are in the shady want/need zone because:

A)Said big-ticket item is a lifestyle enhancement
B)Without payments I wouldn’t take the time (outside of my true long term savings strategy) to create a separate “big ticket item fund”.
C)It’s too much work for a lifestyle enhancement item.

I’m talking a nice tv, large appliance, or large ticket sporting items. As long as you do the math and some sensible budgeting, you can easily snatch up on no-interest deals for 6,12,24 mo’s and be fine with your jam ahead of time.

Posted by Geoff | Report as abusive
 

I’m not surprised by nomad5′s results – in my experience, installment credit (by which I mean catalogue credit) is invariably associated with people who have serious financial problems.

I am not sure which way the causation runs (and suspect that it might be because installment credit is typically so inconvenient and overpriced that the only people who look at it are the ones that nobody else will lend to), but thinking back through all the family and friends and people I grew up with, I can’t think of a single one who had a load of stuff on the catalogue and dealt with their finances sensibly and without drama.

So my conclusion would be that the population of people who need this sort of externally imposed discipline is a lot smaller than Felix or Mike assume. It’s kind of like shutting yourself up in a rehab clinic – which is also a great way of making sure that you don’t ruin your life with drink and drugs, but most people tend to prefer less drastic methods that are cheaper and less inconvenient.

(I seriously disagree with Mike on the “convenience yield” issue, btw – having a $100 payment deducted from your a/c every month gives you 12 opportunities to go overdrawn, with all the associated expense and inconvenience).

Posted by dsquared | Report as abusive
 

dsquared, if your balance is so low that a regular monthly payment presents a risk more than a convenience, the yield could be negative. That should be reflected in the personal discount rate you apply to the offer. Read his and my comments again; the underlying theory helps explain why you would choose one payment method over the other based on your individual risk tolerance and other factors.

Posted by Jacob | Report as abusive
 

[ if your balance is so low that a regular monthly payment presents a risk more than a convenience, the yield could be negative]

well yes, but how many people do you know who a) have enough money that they don’t need to worry about $100 payments driving them negative, and b) have loads of installment credit?

Posted by dsquared | Report as abusive
 

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