In the spirit of midterms, here’s a multiple-choice test for all of the students out there

It’s September, the holidays are coming, and Sally would like to buy a new $200 bike for her son. Right now she only has $25, but she thinks she can probably get the rest of the money together before Christmas. What is the best way for her to buy the bike?

     A) Make the purchase now on a credit card

     B) Use the store’s layaway plan to buy the bike

     C) Save money on her own until she has enough cash for the purchase

If you chose answer “B” we need to talk. Layaway, while not as dangerous as credit card debt, is a bum deal for consumers.

If you’ve spent much time thinking or studying personal finance — especially on this site — we hope that you’ve come to the conclusion that debt is always a bad idea. Borrowing money traps us in financial and spiritual bondage, and costs us lots of money in fees and interest that, over the course of a lifetime, can add up to many thousands of dollars.

A well-reasoned aversion to debt and credit card spending leads some people to make big purchases on layaway plans instead of on plastic. And while we’re glad that retailers are offering cash-strapped folks an alternative to credit card borrowing, we’re no fans of layaway plans. In general, they come with high fees and restrictive fine print that make them a good deal for the retailer only.

In case you’re not familiar with layaway, here’s how it works. Sally goes to the big-box store and finds a bike for her son. She doesn’t have $200 to buy it, and doesn’t want to charge it to a credit card that she can’t pay off. So she goes to the customer service desk and asks to set up a layaway plan. The store agrees to reserve the bike for her and let her pay for it in installments until she has covered the full price. Once all of the payments are made, she gets to take the bike home with her. In order to start the layaway, the store requires Sally to make an initial down payment of 10% of the price ($20 in this case), plus a service fee of $5.

Under this scenario, Sally can start the layaway on the bike with the $25 she has in hand, and then come back and make payments on the bike throughout the next few months. If she pays it off before Christmas, she gets to take home the bike, and all is well. But is it really?

There are a number of factors that make most layaway plans a bum deal. Here are some things to consider:

1) The fees

These days, most retailers charge a fee of $5-$15 to initiate a layaway plan. That is money charged to you on top of the purchase price of the item, and it’s money that you must pay up front. Some retailers will give you that money back at the end of the layaway in the form of a store credit (which is not the same as cash), but many keep the money as part of the cost of the layaway service.

The problem with this is that compared to the value of the items you’re buying, this service fee is relatively high. In Sally’s case, she’s paying $5 for the right to pay off a $180 purchase over three months. That’s similar to paying $5 in interest on a $180 loan over 90 days. If it were a loan, that interest rate over a year would work out to $20, putting the annual interest rate in the neighborhood  of 9%. If Sally is shopping at a store that requires a service fee of $15, the APR equivalent is closer to 30% — an extremely high interest rate on a small purchase. Either way, the cost associated with this plan is inappropriate.

2) The restrictions

In addition to the fees associated with them, most layaway plans have restrictions that make them even more frustrating. Many retailers only offer layaway for the holidays, which means that there’s a time limit on the program. If you don’t pay off the item by Christmastime, you lose out on the layaway — the store refunds your down payment and installments, but keeps your service fee. The same thing happens if you change your mind about the purchase: You get your payments refunded, minus the service fees. These and other restrictions make it less likely that you’ll actually complete your layaway, and more likely that the store will get to keep your service fee.

3) Lost opportunity

Layaway presents a problem that economists call “lost opportunity costs.” This can be a bit tricky to grasp, but bear with me.

Economics tells us that there’s value not only in money, but in the opportunities that money gives us. Every time that you give somebody your money, you lose the opportunity to use that money for something else. Most of the time that we give people money, we’re getting something of value in return, so the lost opportunity doesn’t bother us. But when we give someone our money and don’t immediately get something in return, we lose the opportunity to use that money, and the person who takes it from us gains the opportunity to use it instead.

When you use a layaway plan, you’re giving the store  your money without immediately getting anything in return. That means that you can’t do anything else with the money — you’ve lost opportunity — and the store can do whatever they want with the money. In theory, you could keep that money in a savings account and make a little bit of extra money in interest. Instead, the store is making interest on that money, furthering the profit that they make on a layaway deal. It may seem like a small thing, but over time the cost of lost opportunities adds up.

Conclusions

We’ll admit that layaway is a better plan than any purchase based on debt. But it’s still not a good deal for consumers. The fees, restrictions and lost opportunities add up to make a transaction that benefits the store a lot more than it benefits the customer.

So, what’s the  correct answer to the question? It’s answer “C” — save up money and pay cash for the purchase when you’re ready. It won’t cost you anything extra in fees, and you have the opportunity to spend that money on something else, should the need arise.

And even better yet, why not build your annual holiday spending into your monthly budget, setting aside a little bit each month for your Christmas savings? With a good budget and some discipline, Sally can be ready to buy the bike without having to think about layaway.

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Photo by Andreas Hagerman. Used under Creative Commons License.