Wednesday, November 22, 2017

The High Cost of Paying Property Insurance Monthly

Update: An anonymous commenter says that when a down payment is charged on property insurance, contrary to what our insurance agent told us, monthly payments end after 10 months and not 12.  The article has been updated accordingly.

Recently, I was helping a family member switch property insurance companies. The last thing to arrange was paying the premium. The insurance agent was steering us toward monthly payments instead of paying for the full year in advance.

At first I was just going to dismiss the idea of paying monthly, but I decided to ask the agent what interest rate they charged. I think his exact words were “there is a 4% service fee.”

For the purposes of this article, I’ll scale all the numbers to an annual insurance premium of \$1200 to keep the math simple. I took the insurance agent to mean that they take the \$1200 premium, add 4% to get \$1248, and divide by 12 to get \$104 as the monthly premium. This turns out to be only partially correct.  In addition to the monthly charges, the insurance company wanted a \$200 “down payment.”

This is where the uncertainty comes in.  Although we were told the payments would last for 12 months, it seems plausible that our agent was wrong and that they would end after 10 months.

So, the \$1200 premium led to a total of \$1448 in payments if paid monthly for 12 months. After doing some figuring, I said “that service fee of 4% is more like 4% per month.” The agent’s reply was a simple “yes.” Needless to say, we just paid the full annual amount of \$1200.

Later on when I had time for more accurate calculations, I worked out the internal rate of return on these payments to be 3.58% per month, which compounds to 52.6% per year!

However, if the payments were only going to last for 10 months, then the total paid would be \$1240, and the annual interest rate charged would be 9%.  It's misleading to characterize 9% interest as “a 4% service fee,” but this is a long way from charging over 50%.

I recommend trying to find out the total of all payments you'll make when paying monthly and compare this total to the annual premium.  This will give you some idea of the cost of paying monthly.

1. Usury is such a nasty term, we call it now "Pay Day Loan Levels", much more consumer friendly. Maybe you could call it, "Convenience Costs"?

1. @Alan: I guess those costs are convenient for someone.

2. And there you have the answer to the Annuity Puzzle (previous post).
Why would you get into a contract that has been "crafted" by a battery of lawyers and actuaries working to maximize corporate profits? What would you do if in your senior years the company acted against your interests, sue them (with your remaining dollar)?

1. @Anonymous: I don't blame you for not having much trust in insurance companies. However, I'm not sure how to get through life without entering into contracts crafted by a battery of lawyers. You might want to review whatever you signed when opening bank accounts and trading accounts.

2. Yes life is full of contracts, but in senior years your options are greatly reduced and vulnerability greatly increased.
When the annuity puzzle is discussed the trustworthiness question, is generally omitted

3. You're a math and finance guy?
1) The actual annual interest rate is 10.42%. You can verify the calculation on a declining balance basis calculated monthly. The payments are usually done in month 10 due to the deposit.
2) Most insurers charge 3% not 4%, making the annual rate 7.97%.
3) Not every insurer requires a deposit. If they do, it's usually 2 months, so \$208 not \$200.
4) You're ignoring the cost of administering the payments. Bank charges and other costs eat up most of this fee. Insurers provide financing as a service option, in a highly competitive and regulated marketplace.

1. @Anonymous: When I asked the agent if we'd be paying the \$104 for 12 months, he said yes. If this is true, the annual interest rate is 52.6%. If the agent was wrong and the payments would end after 10 months, the annual interest rate is 8.98%.

The documentation I have clearly shows the down payment as \$200, but if we increase this to \$208, then the annual rate is 10.93%. This is a compounded figure. If we take the monthly rate of 0.8685% and multiply by 12, we get your 10.42% figure.

2. @Anonymous: I find your explanation of our insurance agent being wrong about how long the payments last more plausible than a major insurance company charging 52.6% interest. I'll update the post.