Over the last decade or so, many schools have seen a gradual drift away from lump sum payments to payment by instalment. It is a part of 21st century life that you ‘pay as you go’ rather than saving up and paying upfront: we pay a monthly fee for streaming our music and video rather than buying a CD or a DVD; we pay a service fee for Office 365 rather than buying the licence upfront.
So while lump sum payment of school fees is less common than it once was, where it is offered, we have to ask ‘Is the discount offered worth it?’ The answer to this question lies in our understanding of finance principles.
We need to recognise that there are two parties to this transaction. Firstly, the school which receives cash inflows earlier and can therefore use these funds for other purposes. After all, the discount is being offered so that the school receives the funds at the beginning of the year rather than being drip fed over the course of the year. There is also a risk element here: receiving the payment upfront means there is no chance of default or delay during the year. Secondly, the parent that receives a discount benefit for the full year payment – after all, a discount is pretty much the same as an investment return of interest earned. To work out if this is beneficial to either party, we need to understand the ‘cost of funds’ for each.
Let’s look at an example.
A school offers a 5% discount if a parent pays the school fees upfront for the whole year. Mrs and Mrs A have annual school fees of $10,000 prior to early payment discount, and they would normally pay this off over 12 four-weekly instalments of $833.33 each. Normally, they are earning 1.5% bank interest on their savings. Is this a good deal for Mrs and Mrs A? Let’s say the school has bank loans with a 6% rate of interest, and any funds received can be put towards reducing the bank loan. For the school, forgoing 5% to get 6% sounds good, but is it?
The parents might earn 1.5% on their savings, but they get 5% back from the school – this sounds great – and it is! The table below shows that Mr and Mrs A’s school fee balance reduces from $10,000 down to $0 when paying by instalment, and assuming they have $10,000 in their bank account to be able to consider this option in the first place, they would earn $11.50 interest in the first period, then $10.54 in the second and so on. In order to gain the early payment discount of $500.00, they would forgo $75.38 in bank interest. Let’s not forget that Mr and Mrs A pay income tax on their interest earnings, so the benefit is actually greater – around $450 after tax. In fact, for bank interest to match the early payment discount in this example, Mr and Mrs A would need to earn at a bank interest rate of just over 14% before tax to equal the discount offered by the school. To put it another way, any early payment discount rate above 0.5% is better than Mr and Mrs A’s bank interest alternative.
For the school, assuming Mr and Mrs A paid by instalment, the school would receive $833.33 every four weeks, earning them $3.83 interest in the first period; $7.68 in the second; accumulating and compounding to a total of $304.07 over the 12 periods. However, if they received the net amount after early payment discount of $9,500.00, they would earn $43.70 for the first period, accumulating and compounding to $537.82 – a gain of over $230. One could also argue that the school has their money up-front, and therefore there is no risk of delayed payment or default, which would add additional interest and administration costs. For the school, the comparison is $537.82 interest earned versus [$304.07 less delay or default costs].
It looks like everyone is a winner! However, Mr and Mrs A are greater winners than the school, so in this example, there is scope to reduce the early payment discount rate to make the benefit for the school greater while still providing a decent incentive for the parents.
The above conclusions are based on the single example I have provided. So I was interested to see whether this changes (from a school perspective) according to ranges of early payment discount rates and 'cost of capital' rates - whether that be interest rate earned on savings or interest rate paid on school borrowings. I was pleasantly surprised - there isn't much difference for the ranges of rates used in the comparison table. To be clear, each of the financial amounts in the table is the difference (gain) in interest earned/saved by the school when comparing early payment discounted cash flows with normal instalment cash flows, based on $10,000 school fees; annual early payment discount and 12 x 4 week instalments. This comparison also assumes that the 'cost of capital' for the school is even over the periods involved. Of course, cost of capital can vary seasonally for a school - say moving from interest earned > interest on loans > interest on overdraft.