Many people pay monthly, quarterly, or semi-annually for things they could pay annually.  Consider an insurance policy costing $1000 annually or $87.50 monthly.  How much does it cost to pay it monthly?  In absolute dollars, it’s an easy calculation: twelve $87.50 payments total $1,050 or $50 of annual interest.  But if I have at least $1,000 in savings, the question becomes, “Should I tap savings to pay annually and save $50, or should I leave savings undisturbed to earn interest?”  What does the $50 savings translate into as an interest rate and how does that compare to the rate of return I’m earning on savings?

At first blush one might think paying monthly costs about 5%, since $50 divided by $1000 equals 5%.  However, the outstanding balance to the insurer reduces each month.  Initially it’s $1000, but by year end it’s only $0.  So, the average outstanding balance for the year is around $500, making $50 closer to 10%.  Paying annually effectively saves about 10% on the money you must withdraw from savings to pay annually.

A financial calculator reveals the exact annualized interest cost for this example to be 10.8 %.  But it gets better!  Because interest must be paid with after-tax dollars, saving it is like earning 10.8% tax-free; whereas a 2% money market return, after federal and state income taxes, nets less.  I can effectively multiply my yield five times!  The bottom line is if I have enough in savings to pay annually, I’ll gain a lot more saving finance charges than earning a low taxable interest rate.

If you don’t have a financial calculator and want to know how this relates to your situation, do like we did in the above example: Multiply the monthly payment by 12 to see how much extra you pay vs paying annually ($50); divide this by the annual payment ($1000); double the resulting 5% to 10%.  This will give you a percentage factor.

I wrote this article years ago when one could earn 5% on money market accounts, to show that saving 10% finance charges was a better use of savings.  Since then money market rates have declined, while finance factors with many insurers stayed the same, making the advantage even greater.

For insurance policies, typically you can change to an annual payment mode even if you’re not at the policy anniversary.  Simply ask the company how much is needed to pay to the anniversary.

If you pay annually and decide to drop a policy midyear, typically insurers will refund unearned premium.  You can confirm this when changing to annual mode.

Remember that we are addressing a fine-tuning process for after you’ve addressed more consequential issues such as these:

• Do I even need this product or service?
• Is this the best buy, the right type of coverage, the right duration, etc.

There is also a behavioral dimension that can trump saving finance charges.  The discipline of systematic monthly withdrawals from checking is huge.  If you take the annual payment from savings, it’s important to make monthly payments back into savings.  If you spend even one of these, you will more than unravel the interest advantage you have realized.  Automation beats procrastination!

Saving $50 of interest on an insurance policy may not seem significant, but over many years adds up.  Financially successful people often think in terms of percentages, not just absolute dollars.  Moving savings from earning a taxable 2% to saving an after-tax 10% is a dramatically better use of dollars.