- Your preferences of when you would like to receive or pay money are influenced by the discount rate or interest rate you have in mind
- Research studies found discount rates of about 20% for air conditioners and 45-300% for refrigerators respectively
- Individuals’ discount rates vary by context, the amount borrowed or lent, and even duration of time of the loan/deposit
The is the concluding piece of a three-part mini-series that I am writing on money. This week’s post explores the relationship between time and money. Two weeks ago, we spoke about connotations of money beyond the obvious view of it as a fungible economic resource. Last week, I wrote about the ‘pain of paying’.
The old adage “time is money” is impressed upon us since the time we’re young, even in school. The concept of interest and discounting is part of every primary school’s math syllabus. And by age 10, most of us are familiar with simple interest; a few years later, we learnt about compound interest.
So, is there anything more to the relationship between time and money than is obvious?
If your discount rate is 10%, then you would eschew Rs 100 today for anything more than Rs 110 in a year. Similarly, if your discount rate is lower, say 5%, you would hold out for anything over Rs 105 in a year, and so on
Most readers of FactorDaily have likely availed of banking services — to deposit and withdraw money or to take and repay loans. Let’s start with the concept of time discounting. If I were to give you Rs 100 today, versus Rs 100 in one year’s time, you are likely to choose the amount today. Why is that? First, you get the money immediately; you can either spend it or invest it and get interest. Why, then, would you wait a year for the same amount of money? Except if I were to offer you more than Rs 100 then.
Your preferences are, of course, influenced by the discount rate or interest rate you have in mind. For example, if your discount rate is 10%, then you would eschew Rs 100 today for anything more than Rs 110 in a year. Similarly, if your discount rate is lower, say 5%, you would hold out for anything over Rs 105 in a year, and so on.
So far, the calculations are quite simple. The same holds true for loans as well. You borrow money from the bank now, and usually promise to pay 10-15% per annum interest while returning it (loan repayment rates of banks are higher than interest rates on deposits so that banks can make profits).
The above discount rates seem plausible. But would you expect discount rates of 50% or higher for future payouts? Conversely, how comfortable would you be paying interest of over 50% on a loan?
Consider an energy-efficient electric appliance (geyser, air conditioner, light bulb, etc) that costs more to buy but saves money in the long run. Would you buy a highly priced LED bulb today, knowing well that it will save you money over time, or would you stick to energy-guzzling incandescent lights?
Research studies by Jerry Hausman and Dermot Gately found discount rates of about 20% for air conditioners and 45-300% for refrigerators respectively — figures high enough to surprise most of us. Similarly, the global average interest rate in microfinance is as high as 35% (Uzbekistan leads the pack at 87% and the Indian average is about 20%).
To be frank, microfinance institutions have high operating costs, but their clients are often willing to pay such high rates because of lack of other alternatives from conventional banks, which lend to richer people at much lower rates. Similarly, it is common for Indian credit cards to charge up to 2.5% interest per month, translating to an annual discount rate of about 34.5%.
Keep an eye on your credit card bills. Delayed payments may be costlier than you think. Also, switching to energy-saving lights, refrigerators and other appliances may save you more money than you realise
Such anomalies are discussed in an interesting article by George Loewenstein and Richard Thaler. Economists traditionally assume that individuals have stable discount rates. However, some studies have shown that this is not true — individuals’ discount rates vary by context (as the electrical appliances examples show), amount borrowed or lent and even duration of time of loan/deposit. Thus, discount rates are lower as the time period of the payout gets longer, and increase as the amount borrowed is lower. This is why microfinance institutions and credit card companies are successfully able to charge higher interest rates on small, short-duration loans (25%-80%) compared to what banks charge on home (8.5%-14%) or education loans (9.7%-16.5%), in which both the loan amount and the horizon of repayment are typically higher.
Even if you don’t take small, short-term loans, you may know someone who does. After reading this article, you could educate them about the pros and cons of borrowing money from the local lender (who often charges exorbitant interest rates, much higher than microfinance institutions). You could even help them find out if they are eligible for cheaper bank loans.
As for yourself, keep an eye on your credit card bills. Delayed payments may be costlier than you think. Also, switching to energy-saving lights, refrigerators and other appliances may save you more money than you realise.
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This column is intended to showcase interesting academic research in marketing. The technically oriented reader is encouraged to read the original research articles cited in the column. Prithwiraj Mukherjee is Assistant Professor of Marketing, IIM Bangalore. Views are personal.