The Economics of Rent‐to‐Own Contracts

The Economics of Rent-to-Own Contracts Rent-to-own contracts are a common form of contractual arrangement for many types of durable goods, such as television sets, washers, dryers, pianos, and furniture. With rent-to-own contracts, the consumer is under no obligation to make payments for a given length of time (that is, the contract can be terminated at any time upon return of the product), yet if payments are made through a certain term, the consumer receives ownership of the product. While payments are made on the rent-to-own contract, the dealer usually agrees to maintain and repair the product, unlike a strict purchase arrangement. (1) In most states, rent-to-own contracts are exempt from usury ceilings. Rent-to-own contracts have been criticized for their allegedly high interest rates implicit in the payment stream. For example, in comparing the retail price of the product offered by the dealer to the stream of payments on the rent-to-own contract, the North Carolina Attorney General's office has calculated APRs ranging from 70 percent to over 300 percent on televisions and appliances (Thornburg 1987. In a sample of rent-to-own contracts from Atlanta stores, Swagler (1986) found estimated APRs ranging from 117 percent to 168 percent. A flaw in the previous studies of rent-to-own contracts is lack of consideration of the complexities of rent-to-own contracts; that is, the studies have not considered that the contracts are part rental contract and part purchase contract. Calculation of APRs has been done as if rent-to-own payments are pure purchase payments. The purpose of this paper is to examine the complex economics of rent-to-own contracts and to use the resulting conclusions to calculate implicit interest rates on a sample of rent-to-own contracts. An attempt is also made to explain the variation in implicit interest rates among dealers. DERIVATION OF THE RENT-TO-OWN PAYMENT Consider the derivation of a pure-rental payment (RENT) for a consumer durable good. For the owner-dealer of the durable good to rent the good in period i willingly, the rental payment, [RENT.sub.i], must equal or exceed four component costs (Nicholson 1983). The first cost is depreciation of the good in period i, measured by the product of the depreciation rate in i([D.sub.i]) and the cash value of the good at the beginning of the period, P. The second cost is due to maintenance and repair paid by the owner-dealer and is measured by the product of the maintenance rate in period i([m.sub.i]) and the cash value of the good. The third cost stems from the expense of servicing the contract (collecting and processing payments), which are assumed to be unrelated to the cash value of the good. Servicing costs in period i are thus represented simply by [S.sub.ri]. The last cost is the opportunity cost of having the cash value, P, committed to the good rather than in an investment earning the current interest rate. This periodic cost is [r.sub.i]P, where [r.sub.i] includes a risk componet equal to the same level of risk associated with the alternative use of $P in the form of renting the durable good. Thus the minimum required rent payment in period is [RENT.sub.i] = [d.sub.i]P + [m.sub.i]P + [r.sub.i]P + [S.sub.ri]. For simplicity, assume tht [d.sub.i] and [m.sub.i] are constant fractions of P, that [S.sub.ri] and [r.sub.i] are constant over all periods, and assume simple interest earnings for the oppportunity cost. Then (1) becomes [RENT.sub.i] = dP + mP + rP + Sr. The derivation of ownership payments is more straightforward. If the owner-dealer of the durable good sells the good to the consumer and if the consumer makes periodic payments for a total of n periods, then each periodic payment, [BUY.sub.i], is [BUY.sub.i] = PA(r) + [S.sub.o' where A(r) is the annuity factor, A(r) = r/1 - 1 - [(1 + r).sup.-n], r is the interest rate including a risk compoent, in is the number of payments periods, and [s. …