I'm looking at paying for hosting, and I have prepayment options available:
Prepayment for one year earns a 10% discount, and prepayment for two years earns a 15% discount.
Is it better to pay monthly, or take advantage of one of the prepayment discounts? I'm pretty sure the biggest prepayment is best, but a fellow user suggested he thought the one year was the best option. Are they on to to something?
If you know you'll be using the hosting for the full two years, then go for it!
The only reason not to take advantage of such discounts is if you have reason to believe you won't use the service for that long, or that you may wish to change service providers during that time frame. If this is a company you're never worked with, you may wish to pay month to month for a bit while you decide if you trust them enough to sign up for a contract.
The one year is the better deal if they repeat the offer. It's close to a 20% ROI. Really? How so? Glad you asked. Consider, for 12 payments the average amount of time they have your money is 6 months. Better still, the average time you DON'T have it is that 6 months, as you'd start by having the $full, less each month to $0 at the end. So surely the 10% is on a lesser amount than the full sum. It's close to half, depending on whether the billing is at the beginning or end of month. The return to you is closer to 20%.
Edit - If you pay me $100/mo for 12 months, that's $1200. A 10% discount is closer to a 20% ROI. As the math is more like $120 (discount) / $600 (the average sum you are out for the year). This help clarify?
The part I had a problem wrapping my brain around was figuring in opportunity costs. If you have outside places to put money to earn higher rates of return (like paying down debt), electing for no discount could be optimal. I think the key is to recognize the payment structure has diminishing returns: the one year lump sum earns 10 percent, and the second earns you an additional 5 percent. When put succinctly like that it makes a lot of sense.
I haven't done the math, but for the moment, it seems like if your other investment options are in the 5-10 percent range that guy was right.
EDIT: I built a spreadsheet to verify this. It seems Joe is right, but only if your investment options are above ~12 percent. Under lower conditions, the 2 year deal is better. And above 20 percent and monthly option is better. An interesting paradox of behavioral finance...
I ran an excel spreadsheet assuming that you would deposit the entire amount, withdraw each monthly payment, and interest would be compounded monthly.
For the first deal, you would need to get a rate of 19% to break even. For the second deal, you would need 13%. to break even.
It's highly unlikely that you can find such an investment, So I'd take either one.
