How does a bank make money on an interest free secured loan?

Question

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?

Answer 1

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.

Answer 2

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.

Answer 3

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.

Answer 4

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.

Answer 5

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

Answer 6

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).

Answer 7

It typically comes with a purchase, so at the very minimum, they earn their 3%. So, when you spend $7000 on a purchase, banks make $210 from the purchase. If you paid off your loan according to the term of the 0% financing, banks just made that $210. In the event that you don't pay off your balance when debt comes due, they make more money from the high interest loans.

Answer 8

The accepted answer is complete insofar as the bank-as-originator goes. There is, however, an importantly not-a-scam situation that is common in certain sectors (energy efficiency home improvement being the one relevant to my field of work).

It is entirely possible that a given "0% loan" is not actually 0%, but rather the interest is being paid by a third party. These third parties may have made arrangements with the bank to let the bank market the loans as 0% in order to outsource customer acquisition.

These kinds of loans are used to promote public policy objectives (in my world it's to get people to install energy efficiency equipment that isn't within their own microeconomic benefit, but only marginally so - and there's societal benefits like GHG mitigation or reduction in air pollution if people do this work so society has a reason to foot some of the bill).

So the bank issues you a loan at 4.5% APR, but the subsidizing entity pays the interest part of your bill. The loan, to you, is effectively 0% interest, but the bank is still getting to collect interest. What's more, because it's a massive funding entity covering the interest payments the bank doesn't need to charge as high a rate as normal because default risk is also mitigated here.

Disclaimer: A number of scams will purport to be this kind of scheme. Always check the fine print and/or verify by contacting the third party directly if you smell anything fishy.

Answer 9

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.

Answer 10

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.

Answer 11

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.