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The following guest post was submitted by Jaimie from I’ve Paid For This Twice Already… (RSS)

There are several recurring expenses that people have the option of paying by the month or paying in one lump sum every year. There is usually a fee associated with the monthly payment option, so it would seem on the surface that paying once a year would make the most financial sense. Although as a general rule this is true, it may not always be the case. The answer depends on many factors including what the total amount per year due is, what the fee is (calculated for the entire year) and also, what purposes that money would be serving over the course of the year if not paid in a lump sum.

To illustrate some real life scenarios for this I am going to take two such recurring payments in my own life - my life insurance premium and my auto insurance premium, and why, for us, it makes more sense to pay one of them on a yearly basis and one on a monthly basis, even though they both have the same yearly fee for monthly payments. And then illustrate a completely different scenario (the no fee for monthly payment type) with my son’s preschool tuition. It’s all about scope and scale and what other factors come into play.

First, my life insurance payment, the straightforward example. I pay $300/year for term life coverage for my spouse and I (number slightly rounded for simplicity) and if we choose to pay by the month instead we incur a $3.50 fee every month, so $42/year in fees. So if you look at that from an interest perspective, that is like charging 14% interest (42/300 x 100 = 14%) for the privilege of paying by the month. So if you can budget for it, pay the $300 once a year! Save yourself $42. There is no way you can safely and comfortably beat 14% year after year in any kind of short term investment. (Unless you owe high interest credit card debt. More on that below.)

Now, for my auto insurance payment. I have the option of paying $1000 at once annually (number slightly rounded again for simplicity) or about $84 per month, plus again a $3.50 fee per month for the latter option ($42/year, as before). Since my total due per year is $1000, you could, if looking at the fee in terms of “interest” charged on your total premium, treat this as if you are paying 4.2% in interest for the convenience of paying in monthly installments. Now…. what are you doing with the money if not paying it all at once to your insurance company? Assuming you have the money up front to pay, choosing to pay monthly instead and investing that money in a high yield online savings account at we’ll say 5% interest, you’d earn about $22 in interest (and it is taxable, so really, depending on your tax bracket, more like $15) because you have to pay a 12th of it out to the auto insurance company every month. So clearly, pay it all at once! But…. let’s deconstruct this issue a bit further before we move on. Because right now, that’s not what we are doing.

We are pretty significantly in debt. Instead of paying our auto insurance in one lump sum, but instead paying it month to month because this method frees up more money faster for us for debt reduction. Because our credit card debt has been at 9.9% interest, every dollar we put towards debt reduction is in effect giving us an instant 9.9% return. It is not the clear cut case of saving the money in a savings account and paying it out little by little, because the money we put towards debt reduction is then not available for our auto insurance premium at all. But allowing us to pay a smaller amount monthly vs one big lump payment allows us to put more money faster towards the credit card debt. So for now, it makes more sense for us to in effect pay a 4.2% interest rate on the auto insurance to pay down another 9.9% interest rate. It is all about the numbers.

Another case in which it may make sense to pay monthly vs yearly is when the total amount due yearly is very high and/or the fee is very small (or nonexistent). If there is no fee involved in stretching out the payments (like my son’s preschool tuition bill) there is no real reason to pay in advance at once. I sit his tuition money in our ING savings account at 4.5% interest and make the required payment every two months and earn interest on the balance since his school does not charge a fee for this payment structure. And in my above insurance scenarios, if you pay a $42/year fee for monthly vs yearly payments, there will be a tipping point where the amount you could sit in an interest-bearing savings account would earn more interest (minus taxes) than the fee assesed for paying monthly. This number may be rather high and it might not happen often in a practical sense, but it can happen. My insurance company for example, that monthly $3.50 service charge is the standard charge no matter what the total amount is, and many states have much higher insurance premiums than my state does. Insuring 2 cars in a no-fault state with high rates…. you may be looking at many thousands of dollars a year in payments and it may end up making financial sense to pay monthly, or at least, be a wash as far as interest paid vs interest earned.

So a simple on the face of it problem may actually be more complicated than you’d think. But in general, make sure you’re aware of what consequences your payment choices for your recurring bills hold, and choose wisely. We’d all like to save some money in the process.

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