Why Don't Carriers Push Unsubsidized Phones?

Once upon a time it was possible to find a cheaper data plan if you brought your own phone to a carrier in the United States, but those days are over. Whether you buy your phone subsidized or not, you pay the same rate for data.

That fact got me thinking: why don't carriers push unsubsidized phones more?

Costs of an Unsubsidized Phone

Of course, it is a considerable expense for the customer to purchase an unsubsidized phone, especially for smartphones in particular. Verizon is the one carrier that makes it easy to see what it costs to purchase a no-contract phone on its website, so for all of the examples here, I'm going to use Big Red.

According to VZW's website right now, the unsubsidized price for the Galaxy Nexus is $649.99. That's also what a 16GB iPhone 4S costs, and the price goes up in $100 increments as you add storage to 32GB and 64GB. An unsubsidized Droid RAZR goes for that same $649.99, a Droid Bionic sets you back $589.99, and the new Blackberry Torch 9850 goes for $459.99.

Subsidized smartphones all require data plans, so it follows that the carriers probably make up for the subsidies with those data plans. When you subtract the subsidized price from the unsubsidized price, you find out how much each phone is subsidized. Divide that subsidy by 24, and you find out how much each month the carrier charges you per month to make up for the lower up-front price. Here are the subsidies for those phones:

• iPhone (all varieties): $450 subsidy; $18.75 per month
• Droid Bionic: $390 subsidy; $16.25 per month
• Galaxy Nexus, Droid RAZR: $350 subsidy; 14.58 per month
• Blackberry Torch: $280 subsidy; $11.67 per month

In all of these cases, the amount of revenue Verizon effectively brings in for the data plan falls by more than $10 per month thanks to the subsidies. The two lowest (and therefore likely the most popular) data plans Verizon offers are $20 per month for 300MB and $30 per month for either 2GB or 4GB of data (depending on its promotions). That means Verizon is collecting at most $8.33/month purely for data at the lower level and $18.33/month for data at the higher level on the subsidized Torch. It is collecting at the lowest $1.25/month for the lower level and $11.25 for the higher level with the iPhones.

Verizon's Profitable Zones

Verizon's early termination fee (ETF) for smartphones is $350 minus $10 per month of paid service. So, if you cancel after one complete month, your fee is $340. If you cancel after one complete year, your fee is $230.

ETFs basically exist to recoup the subsidies on phones. This must be the case because they are comically small compared to the lifetime value of the contract.

The least expensive smartphone plan on Verizon for an individual is $40 for voice and $20 for data for a total of $60 per month. That works out to $1,440 over the lifetime of the contract. The only point at which Verizon's ETF entirely covers the lost money of the plan is in the final three months, but that doesn't include any subsidy that is still being paid off. Include that factor, and it's likely to only completely cover the losses in the final one or two months.

Therefore, it's safe to say that lost value from the monthly payments on service is not a factor in the ETF. The question then becomes: when are subsidized phones more profitable than unsubsidized phones for Verizon?

The ETF plays heavily in here because someone without a two-year contract can walk without paying that fee. For the unsubsidized phone to be more profitable, the extra amount the company would have made on data versus a subsidized phone at the time must be greater than the ETF at the time minus the amount of the subsidy the customer wouldn't have paid back at the time they terminate. In formula form:

Extra data money to date > ETF - (subsidy - subsidy payments to date)

Here is a chart showing the amount by which Verizon benefits from having an unsubsidized phone at the various subsidy levels I described above. The values charted are for if a customer leaves after the number of months on the x-axis.

As it turns out, it's a very simple relationship. The amount of extra money Verizon makes per month in data with an unsubsidized phone is exactly the same as the amount of the subsidy that gets paid down every month. Therefore for any given month, it's just a matter of taking the value of the initial subsidy and subtracting the ETF for that month.

The only time Verizon doesn't come out ahead when a customer with an unsubsidized phone leaves is for the first few months with a model that normally has a subsidy less than the initial $350 ETF like with the Blackberry Torch. On all the rest of the phones, Verizon would have made more money with an unsubsidized phone no matter when the customer decides to leave.

And of course if the customer with an unsubsidized phone stays through the entire two-year contract, the amount Verizon ends up ahead on the deal is the value of the subsidy it would have offered on that model.

The Customer's Perspective

Before talking more about the carrier, let's talk about the customer.

Buying an unsubsidized phone is much more expensive than buying a subsidized one. The primary value proposition for the customer in foregoing the initial discount is the ability to take that phone to another carrier without having to pay a penalty. Well, sort of.

Thanks to the dueling GSM and CDMA standards, you can only take a standard 3G phone to one other major carrier in the US. Even world phones with both GSM and CDMA capabilities might not be transferable from one to the other thanks to carrier and device restrictions. For instance, the unlocked and unsubsidized iPhone 4S cannot be used on Verizon or Sprint.

In any event, if you buy an unsubsidized phone, you're going to want to know how big a discount you'll need to get at each month over the next 24 months to come out ahead versus a subsidized phone. You need to know when the ETF plus the amount you would have paid back towards the subsidy is greater than the extra money you put up by not getting a subsidy plus any savings per month. In formula form:

ETF + amt. of subsidy paid back > subsidy + savings from new plan

Here are a few charts of the change in the total amount you pay over the course of 24 months by choosing an unsubsidized phone over a subsidized phone and by switching to a lower cost plan in a particular month. If a number for a month is negative, that means you save money by buying having bought an unsubsidized phone and switching that month. If a number for a month is positive, that means you save money by having bought a subsidized phone and switching that month.

This is the chart for switching to a plan that costs $10 less per month:

If you and your unsubsidized phone switch to a plan that costs $10 less per month, you must do it no later than 14 months after buying that phone to make it worth it if the subsidy would have been $280. As the subsidy goes up, you have more time to wait and still come out ahead. Of course if your new carrier charges an activation fee (or more accurately, doesn't waive it), you will have to switch a month or two sooner depending on the phone.

This is the chart for switching to a plan that costs $20 less per month:

You have much longer to wait if you can swing a $20 discount, which makes sense.

The trick is that you won't be able to pull this kind of money saving switch too many times. The other way you can come out ahead with an unsubsidized phone is if you use it on a carrier that doesn't require a data plan for all smartphones regardless like Verizon does. It will take you anywhere from going 14 months without data (for an otherwise $280 subsidized phone like the Torch) up to 23 months without data (for an otherwise $450 subsidized phone like the iPhone).

Why Don't Carriers Push Unsubsidized Phones?

Subsidies are tremendously useful for the carriers. Many people who are unable or unwilling to pay the higher up front price of an unsubsidized smartphone will go for the reduced initial cost of a subsidized one. That then puts them in data plans that more than make up for that initial subsidy. Plus, advertising fancy phones for low prices, or even "free", gets people's attention.

There's no reason why carriers should get rid of subsidies. However, they can have material effect on a carrier's margins if a big selling new phone has a large subsidy. Unsubsidized phones are more profitable for them, so why doesn't every carrier do as Verizon does and make it easy to browse them as options?

Primarily, it's probably because the main advantage for the customer of getting an unsubsidized phone is being able to walk away from the carrier without paying a fee. "If you buy this, you can leave whenever you want with no penalty!" is an awkward pitch for an industry that has been built around the two-year contract. Early termination fees probably also create a mental block in people's minds that prevents them from thinking about leaving even if they can come out ahead after paying it. Plus, a customer leaving early is most often costlier than the subsidy is.

The example of a plan that costs $60 per month is possible but probably not common. Let's imagine a smartphone user who opts for a plan of $90 per month with Verizon. Let's also imagine this person bought an unsubsidized Android phone (that normally has a $350 subsidy) that can be taken to Sprint to take advantage of one of its $80 per month plans.

Let's say this person is considering switching after 12 months. Based on the math from the previous section, this will allow the person to save either $30 total or $65 if Sprint waives the activation fee. It would be worth it financially to switch.

Verizon will have collected $1,080 total from this customer at the time of this decision. If the person stays for another 12 months, Verizon will have collected $2,160 in total. If the person had bought a subsidized phone and stayed the entirety of the two-year contract, Verizon would have collected $1,810 in total (net of the subsidy). In this particular scenario, by giving the option of the unsubsidized phone the carrier is looking at an upside of $350 and a downside of $730. It had better hope its network is much better in the customer's region than Sprint's is.

As the numbers and considerations change, the upsides and downsides do too. However for almost all of the subsidies I looked at here, the carrier takes in more revenue from a full term contract than it does from an unsubsidized, no-contract customer at the points where it makes financial sense for that customer to switch carriers. Only with the iPhone's $450 subsidy versus an unsubsidized customer who switches after 19 months does the carrier no longer care (it brings in $1,710 either way).

Verizon must worry less about bleeding customers than the others because it makes it the easiest of all to shop for unsubsidized phones. I find that interesting because Verizon itself is not the low cost carrier. Big Red should be more vulnerable to being undercut on price and therefore to seeing unsubsidized customers walk away early, but it must feel confident that its network quality, amenities, and packaging deals will insulate it from mere price sensitivity.

Sprint and T-Mobile, as the low cost carriers, would seem to benefit from a proliferation of unsubsidized phones. However, they are having issues with customer loss. Pushing options that let customers leave without having to think about a termination fee might be a bad idea.

As for AT&T, your guess is as good as mine.

Ending the Balance Sheet Recession Is a Big Task

I mentioned yesterday that I think we're in a balance sheet recession. Further credence, besides that post and the materials linked to in it, comes from the fact that total consumer credit fell during the Great Recession for the first time in the span that such data has been collected:

This graph from the St. Louis Federal Reserve shows consumer credit outstanding. The red line is revolving credit, which includes things like credit cards that are expected to be paid off monthly. The green line is non-revolving credit, which includes debt with specific time periods and payment plans like auto loans (but doesn't include mortgages). The blue line is the two put together.

The blue line only falls twice: very slightly after the savings and loan crisis and then quite a bit during the Great Recession. Non-revolving credit largely only stalled for a bit, while revolving credit plunged. Americans have been working hard at paying down their credit card debt.

The task of ending the balance sheet recession is incredibly big. Here's an idea of the scale.

The website LendingClub.com is a peer-to-peer finance service. People apply to get loans from the site, and it chooses whether or not to approve the loans and what terms to issue loans at. The loans are then funded by users, rather than the site itself. About two-thirds of the borrowers use the money to pay off credit card debt, usually consolidating it into a single loan with a lower interest rate than what credit cards charge. For them it's a way to transform revolving debt into non-revolving debt, which always carries a lower interest rate.

As far as I see it, arrangements like these are great. People with excess cash can make far better returns on it than the interest that savings accounts and CDs pay, while people with high interest debt can lower their rates. Of course there are risks for investors greater than the risks associated with deposit accounts; there has to be for it to pay out higher returns. Still though, both sides of the transaction benefit greatly. The intermediary in the form of the website itself charges lower fees than banks do for similar services because it's just a website. It has no branches or ATMs to maintain. It's a win-win-win for regular people.

As great a deal as this is, and it is growing rapidly, it has lent out just short of $500 million. Using the stats provided at the time of writing, $331.6 million of that went to helping people pay down credit cards. That's a heck of a lot of money. It's also a mere drop in the bucket.

According to the Fed data, the peak of US revolving consumer debt was $972.2 billion in September of 2008. It fell to $798.3 billion in November of 2011, the most recent data point at time of writing. That's a drop of $173.9 billion. As great a deal as Lending Club is, it has contributed towards less than 0.2% of the fall in credit card debt. Its data goes back into 2007 when it started, so not all of that $331.6 million has gone toward people deleveraging since the financial crisis began.

Credit card debt is only a part of the story anyway. Mortgages are still on top, and until housing prices quit falling, there won't be much demand for newly built houses. That's doubly important because construction jobs weigh heavily in the current unemployment mess. Plus, student loans passed up credit cards for the No. 2 spot on the US debt charts.

Lending Club is an ingenious way to help people get out of credit card debt, but it barely registers on the overall scale of the problem. Credit cards themselves take a back seat to mortgages and student loans now in terms of total debt outstanding. As long as Congress is going to hold up progress towards debt relief and real effective jobs programs, it's going to take a lot of ingenious ideas to dig the economy out of the ditch its currently in.

A Balance Sheet Recession

The most compelling explanation to me for the shape of the US economy is economist Richard Koo's "balance sheet recession" idea. If you have the time, I encourage you to read his full paper [PDF] on the topic. Here is an hour-long lecture he has given on the topic. This video embedded here is a quick 10-minute explanation.

Monetary policy is insufficient to solve the current US economic problems, as the real interest rate has been near zero for years now with no dramatic turnaround. The reason, as given by Koo, is simple: providing even the cheapest possible credit won't make a dent when people have no appetite for borrowing whatsoever.

Demand among the citizenry will be depressed as long as the people, on the whole, are deleveraging. Increased saving and debt repayment rates necessarily mean that consumption rates will fall. Koo suggests that governments should run a deficit during times of balance sheet recessions, as a government running a budget surplus is basically doing its equivalent of saving.

This is paradox of thrift territory, and the concept is more compelling here than under normal conditions. Generally, saving doesn't necessarily have to be a bad thing; banks lend out deposits, which then gets those funds back flowing through the economy. Except that, remember in a balance sheet recession that the demand for credit is low. When you have wounded and vulnerable banks (who are facing stricter capital requirements to boot) as we have now, the supply of credit falls too. Declining private sector credit demand and supply would only be made worse by the government running a surplus.

Koo therefore warns against austerity by governments during balance sheet recessions. After all, governments with their own currencies have more options for dealing with debt than individuals and businesses do (and many of those that don't are causing the Euro debt crisis). The fact that the US, which went with stimulus in 2009, is doing better than European countries that went the austerity route lends credence to this prescription. An economy simply can't grow if everyone from consumers to businesses to the government all pay down debts at the same time.

Koo developed his balance sheet recession idea while studying Japan's problems of the last 20 years, he believes it describes the US in the Great Depressions well, and it seems to fit for the current US as best as I can tell.

How Get Rid of Your Pennies

I'm all for getting rid of the penny. It's time of usefulness has come and gone, and this video makes a pretty concise and compelling case for it.

The only problem I have with this video is that it contends that Coinstar machines are the only machines that accept pennies. Not true. In fact, the other machines that accept pennies are typically found in the same place that Coinstar machines themselves are.

Self checkout machines at grocery stores are common where I live, and among grocery chains that I am familiar with (just about all that operate in the southeast), only Publix does not have them. The self-checkout machines do, in fact, accept pennies. They also allow you to pay partially in cash and partially with a card, meaning that you can actually use pennies by dumping a few in the machine before swiping your debit or credit card per normal.

Of course, doing this fails the time test that the video mentions. It's almost certainly not worth your time while you wait for the self checkout machine to digest a large amount of pennies, especially since some will be rejected and will have to be submitted twice. I certainly wouldn't do something like this during prime time at the store either, as you will inconvenience people behind you in line.

However, the self checkout is the best place to spend your pennies. You don't lose a percent of them like with the Coinstar machine, and you actually do use them and keep them in circulation. It might not be the best use of your time, but if you maximized the value of every second of your time, you wouldn't be surfing blogs like this anyway.

Periodically filling your local self checkout machine with pennies is the best alternative of a lot of bad ones until the most useless of coins finally does go away for good.