In November, we paid in full three different bills totaling close to $3,000 that weren’t due (or due in full) for 5 or 6 months.
Why did we do this? Quite simply, the pay in full or pay in advance discounts amount to some of the best ROIs around. How so? Let’s look at some examples.
We get our property tax bills in November every year, but technically we don’t need to pay them until March of the following year. That’s 4 months that we could hold on to the cash instead of handing it over to our local government for them to hold on to. Four months when we could be earning interest on our money instead of letting our local government put it to use immediately (or earn interest on it themselves).
To induce us to hand over our hard-earned cash as early as possible our government gives us a nice little discount to pay in advance. For each month we pay in advance of March, we get a little more than 1% off of the total bill. So if we pay as early as possible (in November), we get 4.17% off the total bill. 4.17% might not sound like much, but let’s annualize it.
4.17% for 4 months becomes…
(1+0.0417)^(12/4)-1 = 13.03% annualized.
Unless your savings account is getting a better return (CAGR) than that, or you are using your funds to pay down credit card or other debt that’s at a higher rate than 13%, I really can’t see any downside to not prepaying this bill. And if you’re using an escrow account through your mortgage holder, make sure they’re paying it early to get the maximum discount, too!
If you weren’t impressed with the ROI on prepaying property taxes, let’s take a look at what the ROI is when you pay your car insurance in full every six months instead of paying it on a monthly basis. (Something Mr PoP had never even thought about doing before we got married and I told him he/we needed to be taking advantage of the pay-in-full discounts!)
Our most recent renewal rate was $298.84 for 6 months of car insurance premiums. (That’s for 2 drivers on one car – and it’s about $30 less than our last renewal, so yay!) We could pay $298.84 all at once, or we could pay $68.87, then four more monthly payments of $68.85, followed by one last payment of $68.80. Altogether the total for the monthly payment schedule is $413.07.
Prepaying gives a savings of $114.23, which is a total discount of 27.7% on the total bill. 27.7% seems good enough to get your attention, but that’s not the end of the story. To that, we look at the internal rate of return (IRR) you’d need to be earning on a savings account that would allow you to put in $298.84 and pay out according to the 6-month bill schedule, and end with a zero balance after the final payment. In this case, the IRR is ~82%.
You’d need a savings account earning 82% interest each year to be able to deposit $298 and withdraw those 6 monthly payments and end with a $0 balance.If you’ve got one of those, then by all means pay monthly. But if not, you’re better off paying car insurance all at once with this kind of prepayment discount.*
And these are just the tip of the iceberg. There are many other places that prepayment discounts come up – cash prices for health care, race entry fees for sports events, tuition / day care, etc.
Is Prepaying Always A No Brainer?
Well, there can be some downsides to prepaying to consider as well.
- Prepaying can transfer some risk to you. If the company goes out of business or otherwise decides not to honor the payments that you have made, you’re at a disadvantage because you need to fight to get your money back. (And that doesn’t always work as I found once…) Paying with a credit card can mitigate some of the risk since the credit card companies generally all have some sort of purchase protection insurance on them, but you’re still left to deal with the hassle of the claim.
- Prepaying can induce you to overbuy. This is really what a lot of marketers are hoping for when they offer a discount for making a purchase *rightnow*. Whether it’s putting a deposit down for your next cruise where $100 gets $300 in cruise credits or stocking up on Groupons for services that you would have never thought about purchasing before seeing the Groupon. By prepaying for these deals you’re often locked into spending both time and money on some future date that you hadn’t explicitly planned to. And that’s how you’ve overbought. So try and only prepay for something you know you would purchase anyhow.
- Prepaying can decrease your leverage with a service provider. One prepayment option that Mr PoP and I have considered but haven’t pulled the trigger on yet is our pool maintenance. We pay $65/month for pool service (I swear it’s cheaper than us DIY-ing), and we could prepay 11 months and get the 12th month free. This equates to an 8.33% discount over the course of the year, and like the car insurance the IRR would actually be higher (though not as high as the 82% for the car insurance!). So why haven’t we done it? Simply because as we currently do not have a contract, we’re pretty sure the quality of our service would decline once the pool service provider has a large chunk of our money. As it is, our pool guy tends to get lazy and I need to write a note on the bill every few months along the lines of “Pool has not been vacuumed according to schedule. Please address.” And then our pool gets vacuumed. Until we get a really fastidious pool guy, we’re not likely to be prepaying this one.
So you need to balance the prepayment discount (and the IRR or CAGR that you achieve through it) with the some of the downsides of prepayment to make sure it’s the right decision. But for us, more often than not, we grab that prepayment discount as long as it’s something we were sure we would buy anyhow!
* Mathematically you’re even better off charging the prepayment total to a credit card and paying the card down monthly according to the car-insurance payment schedule. Even with an interest rate on the card as high as 18%, you’d pay it off in full about 6 weeks early.
What kinds of prepayment discounts do you take advantage of? Which do you pass up?