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I was having a discussion about the ethics of charging interest on a loan, and I was of the position that allowing the charging of interest encourages more loans to be given, and thus contributes to economic growth and prosperity. Therefore it is a moral good.

However, it got me thinking. Sometimes a bank or loan company will offer loans at 0% interest. I have made use of loans like this myself in the past. But why would they do this? How is money made? Could lenders even continue to operate if charging interest was banned and all loans had to be made at a 0% rate of interest?

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    A good question - just remember - the bank always wins. They don't do it if they don't make money on it. So you're right to question "hey, it sounds like they can only lose money on this, so why do they do it?" Usually, when you can't tell where the money is coming from, you're about to get ripped off in a surprising fashion and there's nothing you can do because hey, you signed the paper without reading the fine print. – corsiKa Aug 16 '17 at 21:08
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    Did you actually get your 0% interest loan in cash, or was it bundled with a purchase of some sort? – Dmitry Grigoryev Aug 17 '17 at 9:10
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    "moral good"... Why do you think there are crisis everywhere? :-) – algiogia Aug 17 '17 at 9:55
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    Maybe it's 0% as long as you keep up the payents, with hefty penalties for failure to do so? – Mawg Aug 17 '17 at 13:32
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    I don't have the details right at my fingertips but look up lending for muslims. Islam has some sort of prohibition on interest, but like all people they have to do business too, so there are lending structures that are not interest based. en.wikipedia.org/wiki/Islamic_banking_and_finance is a quick link. Money.SE and Islam.SE both have had threads on this also. This would answer your question on how to make money at 0% and address your unasked but stated morality interest. – Freiheit Aug 17 '17 at 13:57
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A "true" 0% loan is a losing proposition for the bank, that's true. However when you look at actual "0%" loans they usually have some catches:

  • The interest actually accrues at some rate but is not due unless the borrower "defaults" (misses a payment). The bank makes money when people miss a payment, and they get to add on all of the accrued interest to the loan.
  • The 0% is for a certain time frame, and after than the interest rates jumps. They make money when you don't (or can't) pay off the loan during the 0% period and then must pay interest for the remainder of the loan.

There might also be late payment fees, prepayment penalties, and other clauses that make it a good deal on average to the bank. Individual borrowers might be able to get away with "free money", but the bank does not look to make money on each loan, they look to make money on thousands of loans overall.

For a retailer (including new car sellers). the actual financing costs will be baked into the sales price. They will add, say, 10% to the sales price in exchange for an interest-free loan. They can also sell these loans to an investment bank or other entity, but they would be sold at a deep discount, so the difference will be made up in the sales price or other "fees". It's possible that they would just chalk it up to promotional discounts or customer acquisition costs, but it would not be a good practice on a large scale.

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    +1, I'd just add that on items like jewelry where the retailer and lender are in some sort of common ownership arrangement the 0% loan facilitates increased sales price and volume and a stream of future revenue against the risk of just the cost of the item, where the lender is a separate entity the entire sale price must be lent (less a down payment). A $1,000 ring might only cost $200 for you to manufacture or buy at cost, with a sale via loan you get your inflated $1,100 sale price from someone who couldn't have paid the $1,000 anyway and your actual risk is only the $200 cost to you. – quid Aug 16 '17 at 19:11
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    @Quid true - that's what I was trying to convey in the last paragraph. – D Stanley Aug 16 '17 at 21:05
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    As well, banks are allowed to loan out money they receive multiple times to other people as it gets paid back - for example, after I pay back $1,000 to the bank, they can take that money and loan it out x number of times to other customers – Canadian Luke Aug 16 '17 at 22:15
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    @CanadianLuke Yes, but they still want a return when they loan it out again. Why wouldn't they? – D Stanley Aug 17 '17 at 13:23
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    All great, but there is another powerful indirect reason for these loans, common cognative biases about money. Many people are more willing to agree that a certain price is reasonable if it is a distant theoretical cost of the future then if it's something that they have to pay now. Sellers promising one doesnt have to pay till that distant future can often either sell at a higher cost or sell an item one doesn't really need /can't afford by appealiing to this bias to encourage impulse buys. These impulse buyers often fail to pay the loan off on time allowing charging of full interest. – dsollen Aug 18 '17 at 13:00
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Most 0% interest loans have quite high interest rates that are deferred. If you are late on a payment you are hit with all the deferred interest. They're banking on a percentage of customers missing a payment. Also, this is popular in furniture/car sales because it's a way to get people to buy who otherwise wouldn't, they made money on the item sale, so the loan doesn't have to earn them money (even though some will).

Traditional banks/lenders do make money from interest and rely on that, they would have to rely on fees if interest were not permitted.

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    It seems to me that interest free financing has replaced 'layaway'. This makes a lot of sense from the retailers perspective because they get to move the inventory out. – JimmyJames Aug 17 '17 at 14:59
  • @jimmyjames: interest-free financing to offload inventory suggests we are nearing the end of a credit boom and near another recession, and that the people taking these are underbanked due to the effects of the previous recession. Also remember that US subprime auto loan average term length is currently at a historical record of 84 months(!), as are delinquencies. – smci Aug 21 '17 at 3:17
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    "Most 0% interest loans have quite high interest rates that are deferred." Only in the US, I suspect. I strongly suspect that most developed-world countries' laws forbid deceptively selling a high-deferred-rate loan as "0%". – smci Aug 21 '17 at 3:26
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    @smci in the EU too, though the wording would be different. Most often they advertise with an "interest free loan" and then in tiny print almost too small to read that's flashed on screen for a fraction of a second state "for the first 3 months, after that our normal rates apply" or something like that. – jwenting Aug 21 '17 at 9:03
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Generally speaking, an interest-free loan will be tied to a specific purchase, and the lender will be paid something by the vendor. The only other likely scenario is an introductory offer to try to win longer-term more profitable business, such as an initial interest-free period on a credit card. Banks couldn't make money if all their loans were interest-free, unless they were getting paid by the vendors of whatever was being purchased with the money that was lent.

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    " unless they were getting paid by the vendors..." that is exactly how credit card companies make money even when their customers clear the debt every month with no interest payments. The merchant pays a fee to the card company to process the transaction when you use the card. At least in the UK, the customer can't see this because it is illegal to sell goods at different prices depending on the payment method used, but if you pay by cash instead of by card, the merchant makes more profit on the sale. – alephzero Aug 17 '17 at 11:53
  • @alephzero: Which is why sometimes one can get a cash discount as the merchant doesn't have to pay processing fees. – No'am Newman Aug 17 '17 at 12:56
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    @alephzero The EU has now capped credit card fees at 0.3%, which isn't very much, and banking cash isn't free either. There's now very little difference in the costs of accepting cards or cash. – Mike Scott Aug 17 '17 at 13:05
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    I can confirm that vendors pay significant fees to lenders for an interest-free arrangement. The music store I once worked in had an arrangement where 8% of the purchase price on a 0% interest purchase was paid to the lender in fees. So, the bank gets their cut, the vendor gets a sale they may not have otherwise made, and the purchaser gets something without needing to outlay the entire purchase price. In theory, the vendor misses out on a % of profit, but a cash buyer would likely negotiate a similar % off the asking price. – Vocoder Aug 18 '17 at 4:08
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    And of course if you take the interest free loan more often than not it comes with a high amount of "handling fees", "brokerage fees", etc. etc. that come out to more than that 8% of the purchase price, and thus more than the normal interest rate on a regular loan... – jwenting Aug 21 '17 at 9:04
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The bank depends on the laws of large numbers. They don't need to make money on every customer -- just on average. There are several ways that zero interest makes sense to them:

  • customer acquisition is expensive. Their marketing department knows exactly how much it costs in advertising and marketing costs, on average, to pick up a new customer. They even budget for this, so they have a "kitty" of funds to spend. Spending some of that money subsidizing a new customer's interest is a perfectly reasonable method.
  • The zero interest period lapses - at which point a higher interest rate takes over. This is all but certain. A person could carefully manage this relationship so they pay it off before then, but the bank is betting the customer will not, or will not be able to, and will acquiesce to the interest. Many people don't really read their statements and won't even notice the interest.
  • This only applies to balance transfers and/or cash advances, and these have high one-time fees, which more than make up for the zero interest.
  • Membership has its privileges. You are a preferred customer with a lot of money on deposit or in investment accounts, on which they make a lot of money -- and the zero interest is a perk (perquisite).
  • They are charging you a punishing interest rate, but are agreeing not to make you pay it unless you default. Then all the back interest is due, plus interest on the interest.

You asked about banks, and I don't think you see this last scheme in use very much by a bank. Here's why. First, customers absolutely hate it - and when you drop the interest bomb, they will warn their friends away, blow you up on social media, call the TV news consumer protectors, and never, ever, ever do business with you again. Which defeats your efforts in customer acquisition. Second, it only works on that narrow range of people who default just a little bit, i.e. who have an auto-pay malfunction. If someone really defaults, not only will they not pay the punishment interest, they won't pay the principal either! This only makes sense for secured loans like furniture or cars, where you can repo that stuff - with unsecured loans, you don't really have any power to force them to pay, short of burning their credit. You can sue them, but you can't get blood from a stone.

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If interest rates are negative, a 0% load might still be profitable.

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    +1. If it actually costs the bank interest to just have the amount sit on their central bank account, it's cheaper to loan it out for 0%. – RemcoGerlich Aug 18 '17 at 14:37
  • Yes, but 0% consumer credits had already been around when bank interest rates were still positive – Hagen von Eitzen Aug 21 '17 at 4:17
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Other answers didn't seem to cover it, but most "0%" bank loans (often offered to credit card holders in the form of balance transfer checks), aside from less-obvious fees like already-mentioned late fees, also charge an actual loan fee, typically 2-3% (or a minimum floor amount) - that was the deal with every single transfer 0% offer I ever saw from a bank.

So, effectively, even if you pay off the loan perfectly, on time, and within 0% period, you STILL got a 3% loan and not 0% (assuming 0% period lasts 12 months which is often the case).

  • Depends what country you're in. In the UK, the quoted interest rate must include the effect of fees over the life of the loan. – Mike Scott Aug 17 '17 at 5:03
  • @MikeScott - in US there's APR and interest rate, APR is what you referred to. – user2932 Aug 17 '17 at 13:11
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    That 3% fee on a 12 month no-interest loan is actually the same cost as 6% APR, because half of the money is borrowed for less than 6 months. – Ben Voigt Aug 17 '17 at 19:26
  • @BenVoigt What trick am I missing? Paying off the loan with the 3% "fee" over 12 months does not equal 6% over 12 months... – Xen2050 Aug 18 '17 at 14:25
  • @xen it's really close. You pay 3% on the portion you pay off in one month, same as the last payment which you got to hold for 12 months. The effective interest rate on that first payment is 3%/month or 36% APR. – Ben Voigt Aug 18 '17 at 15:15
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Car dealers as well as boat dealers, RV dealers, maybe farm vehicle dealers and other asset types make deals with banks and finance companies to they can make loans to buyers. They may be paying the interest to the finance companies so they can offer a 0% loan to the retail customer for all or part of the loan term. Neither the finance company nor the dealer wants to make such loans to people who are likely to default. Such customers will not be offered this kind of financing. But remember too that these loans are secured by the asset - the car - which is also insured. But the dealer or the finance company holds that asset as collateral that they can seize to repay the loan. So the finance company gets paid off and the dealer keeps the profit he made selling the car. So these loans are designed to ensure the dealer nor the finance company looses much. These are called asset finance loans because there is always an asset (the car) to use as collateral.

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In addition to all the points made in other answers, in some jurisdictions (including the UK where I live) the consumer credit laws require the lender to allow the borrower to pay off the loan at any time. If the lender charges interest and the borrower pays off the loan early then the lender loses the interest that would have been paid during the rest of the loan period. However if the actual interest is baked into the sale price of an item and the loan to pay for it is nominally "0%" then the borrower still pays all the interest even if they pay off the loan immediately.

If you think this game is being played then you can ask for a "cash discount" (or similar wording: I once had problems with a car salesman who thought I meant a suitcase full of used £20s), meaning you want to avoid paying the interest as you are not taking a loan.

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Very good answers as to how 0% loans are typically done. In addition, many are either tied to a specific large item purchase, or credit cards with a no interest period. On credit card transactions the bank is getting a fee from the retailer, who in turn is giving you a hidden charge to cover that fee. In the case of a large purchase item like a car, the retailer is again quite likely paying a fee to cover what would be that interest, something they are willing to do to make the sale. They will typically be less prone to deal as low a price in negotiation if you were not making that deal, or at times they may offer either a rebate or special low to zero finance rates, but you don't get both.

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