Layaway? Stay away

This holiday season, retailers are bringing back a popular payment option of times past: layaway. Is it as good an idea today as it was back then?

Although layaway looks like a good deal on the surface, deeper analysis shows that it's a flawed way to pay. Other options are more financially sound and will save you more money in the long run.

How layaway works

Stores offering layaway from October through December this year include Toys 'R' Us, Best Buy, Sears, Wal-Mart, Marshalls, Kmart and TJ Maxx. Typically, when you put an item on layaway, you must put down a deposit of 10-15 percent of its cost and pay a service fee, usually $5 or $10. When you pay off the balance, the item becomes yours. If you breach the contract by not paying or canceling, you will likely pay another fee of $5 or $10. Any payments left after the fees are returned to you either in cash or store credit.

Layaway fans argue that you don't have to pay interest on items and that it prevents you from putting money on a credit card. But the case against layaway contains a more substantial list of problems:

1. The financing is unfavorable

Because you don't technically pay interest, layaway may sound more attractive than other types of financing. But in reality, the initial fee you pay acts as interest. And when you calculate that effective interest rate on a layaway loan, you'll discover it's quite high.

Say you want to put a $200 item on layaway and you're required to put 10 percent down ($20), pay a $10 initiation fee and pay the balance in 60 days. Essentially, the store is loaning you $180 for two months. That equals an annual percentage rate (APR) of about 33 percent, which is higher than the APRs on most credit cards. In comparison, on a credit card with an APR of 20 percent, the interest on this same loan would total about $6 -- or just more than half of the layaway fee.

2. Every fee equals lost money

A $5 fee here and there doesn't sound like a lot, but together these fees add up. If you put multiple items on layaway, the amount you pay in fees could've covered the cost of an additional item. With five items on layaway, for instance, you pay $25 to $50 in fees, and that's assuming you pay off all five balances in time. If you don't, you'll pay even more. If you simply purchase the items later in the season when you have the money, you won't pay any fees. So each fee you pay with layaway is money that could have toward another expense had you waited.

3. You forgo sale prices

When you put an item on layaway, you're locked into its price at that time, which is often full price. So even if the item goes on sale later, you're stuck paying the full cost. The odds of sales taking place during the winter holidays, particularly in a sour economy, are pretty good. During those sales, the original prices could fall by 20-70 percent, offering you significant savings. Worse yet, some stores prohibit you from placing clearance items on layaway.

4. Too many rules and restrictions

Each store has its own layaway policy, rules and fees. Some have a layaway minimum. Some dictate what percentage of the cost your second payment must be. Some mandate you pay the second installment by a certain date. Some require you pay the balance within 30 or 60 days. Some have restrictions on what merchandise you can lay away. With so many parameters, you need an organizer just to keep all the details straight -- all for a deal that doesn't make much sense to begin with.

Alternatives to layaway

Fortunately, there are plenty of options besides layaway for holiday shopping. You might sock away a bit of money throughout the year in a savings account to fund your holiday purchases. You might consider opening a Christmas club account at your bank or credit union. The Christmas club option allows your financial institution to automatically transfer a predetermined amount each month from your checking account. So by the time the winter holidays roll around, you've already accumulated your funds for gifts. You might even use a credit card -- just be sure to pay the balance promptly to avoid excess finance charges.

By choosing one of these options, you can help make layaway a thing of the past again. After all, every $5 you save counts.

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