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Interest-free finance: how it really works
By Tammy May

How interest-free finance worksWe’ll soon start to see mid-year sales pop up. If you’ve been saving for something special, the sales might be a good time to go shopping. But retailers will also try tempting you to spend money you don’t have. One of the tricks up their sleeve is interest-free finance.

I’ve seen lots of people burnt by interest-free deals. Some of them didn’t understand how interest-free loans work and others got caught out by unexpected life changes that meant they couldn’t pay off the loan in the interest-free period. Either way, it pays for us to talk about the potentional dangers of interest-free financing.

It begins with supply and demand…

Consumers want to buy stuff and merchants want to sell stuff, but many people don’t have enough money in their pocket to afford stuff. To get over this hurdle, many merchants partner with finance companies (GE CreditLine is one example) to offer consumers buy-now-pay-later deals. The terms may differ, but the advertising usually goes something like “Zero deposit and no interest for 18 months!”

Unlike lay-by, where the goods stay in the store, interest-free financing allows you to take the goods home immediately. Wow! Sounds like a great deal — and sometimes it is — but you need to make sure you understand exactly how it works.

Interest-free finance is a loan

A lot of people don’t initially realise that buy-now-pay-later deals are actually a loan. In most cases, they are a revolving line of credit, just like a credit card. As you pay down the balance you may borrow again from the line of credit up to your approved credit limit.

To apply for interest-free finance, you complete a credit application (usually at the merchant’s premises) and the finance company accesses your credit file to assess your application. Whether you are approved or declined, the enquiry will appear in your credit history.

How interest-free loans go wrong

The finance company is only obliged to tell you what your minimum monthly repayment amount will be: three per cent of the outstanding balance or $25, whichever is greater. This catches a lot of people out. In most cases, the minimum required payment is not enough to repay the loan balance within the interest-free period. Any outstanding balance at the end of the interest-free period will begin attracting interest charges, often at around 20 per cent per annum - ouch!

To avoid paying any interest you must pay the outstanding balance in full before the interest-free period ends. To calculate the necessary monthly payment, divide the outstanding balance by the remaining interest-free months (eg. $1,200 balance divided by 12 interest-free months = $100 per month.)

Get off the credit wheel!

Most people take out an interest-free loan because they see it as a stop-gap measure (“I’ll pay the balance off next month when I get my tax refund/bonus/commission etc.”) or as a financial strategy (“Why give the store my money when I can keep it in the bank?”) but the finance company is hoping to seduce you into a lifelong love affair with credit. You can expect to be enthusiastically wooed and heartily encouraged to use your line of credit for new purchases, credit balance transfers and cash advances. After all, that’s how finance companies make their money.

Be especially careful about drawing cash against your line of credit. There is no interest-free period for cash advances. Cash loans begin attracting interest immediately and often at a higher rate of interest.

In a nutshell…

  • Avoid using credit for consumer purchases — get in the habit of saving up for what you want.
  • Ask about lay-by instead of interest-free finance.
  • Make sure you understand any application fees, as well as the interest rate and charges that apply when the interest-free period ends.
  • Do not apply for interest-free finance if you suspect your application will be declined.
  • Work out if you can afford the real monthly repayment amount by dividing the purchase amount by the number of months in the interest-free period.
  • If the finance deal includes no payments during the interest-free period, make the payments anyway.
  • Pay off the balance in full before the interest-free period ends.
  • Close your account as soon as the balance is paid off.
  • Do not opt-in for credit limit increases.
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