If soaring gas prices and environmental concerns haven't scared you away from the car of your dreams, you've still got to decide if you'll buy or lease, which is where the real fun begins.
By John Caspar
June 10, 2008
When you're in a new car mood, there are questions that must be answered. First among them, of course, is the question of whether or not you really need a new car at all.
In aggregate, new car purchasers discard their cars with lots of usable life still in them, so odds are you don't need a new vehicle. And environmental sensitivity may lead you to consider that a slightly less efficient older car that already exists is a lot better for the planet than manufacturing yet another car.
The thing is though, you want to buy one anyway because, darn it, you just feel like it. Now, your left brain hemisphere is fairly shrieking that buying a used vehicle is smarter, that keeping the old car is smarter, blah blah blah. All that analytical noise can be irksome when what you really feel like doing is getting a nice new shiny set of wheels with more horsepower, more airbags, and more cup holders. So what do you have to do to get rid of all that cognitive dissonance that might prevent you from getting the toy that you want? Occupy your left hemisphere (and perhaps your better half) with lots of analysis about car lease versus car loan versus (if it's an option) all cash. That's what this column is about.
This will entirely distract the weenie killjoy part of you, allowing the irrational side of you to have some fun and throw good money out the window. Hey, I'm here to help. And, of course, you can refer to this analysis even if you actually do need a new car.
First let's look at a vehicle loan versus a vehicle lease. When you buy a vehicle with a loan, you put down an initial deposit or down payment on the car, and pay the balance over a prescribed period. The set monthly payment you make includes both interest and principal components. When the term of the loan ends, you own the car outright.
When you lease a vehicle, you put down an initial deposit or down payment, and make set monthly payments over the term of the lease, just like a loan. The monthly payments, however, are not designed to retire the entire outstanding liability on the price of the vehicle. The leasing company makes an assumption based on experience that the vehicle will have a minimum value at the end of the lease term. That value is called the residual. The lease payment is set so that at the end of the lease term, there will still be an outstanding balance owing on the vehicle. That outstanding balance is equal to the residual value - what the lease company thought it would be worth.
Your lease payment, then, is a blend of principal and interest on the original price of the vehicle minus the residual, plus interest on the residual amount. If you leased a $45,000 car with a residual value of $20,000 after forty-eight months, you'd pay principal and interest on $25,000 ($45,000 - $20,000), plus interest only on $20,000. At the end of the forty-eight months, there would be $20,000 left owing on the car. Depending on the type of lease, you may or may not be at risk for any difference between the residual and the market value of the vehicle.
Vehicle leasing is very popular because the financing structure in a lease means that the monthly payment is lower than a vehicle loan of the same value. New car guys love it. I've been met at the door of car dealers with the line "What kind of monthly payment can you afford?" In terms of cash flow, leasing looks great. But what's a better deal really, a loan or a lease?
Tax advantages sometimes get talked about vaguely on the showroom floor of new car dealers. We'll dispense with such discussion here except to say that for the first couple of years, leasing provides greater deductibility, and over four years, it's a coin toss. Because most people can't deduct their vehicle costs or have more vehicles than are deductible, we'll ignore any comparative tax benefit a lease might provide to someone who traded a vehicle in every two years.
The biggest difference between a car loan and a car lease is the fact that the loan involves a purchase transaction, while the lease is a rental. For example, if you decide to purchase a $45,000 car in my home province of B.C., that purchase would attract a 12 percent sales tax - a 7 percent provincial sales tax, plus 5 percent in federal GST. Your total capital required to buy the car, then, would be $50,400.
When you lease a car, the car you are leasing still shows on the balance sheet of the lessor. No sale has occurred, so there is no sales tax levied on the purchase price. The car cost is $45,000, and that's what the lease is figured on. The sales tax you'll pay will be on the monthly lease payments.
Let's run some numbers for your left hemisphere. Let's assume that you put nothing down on either the loan or the lease, and that both the loan and the lease are done at an interest rate of 6 cent. (These assumptions are done just to make sure we're comparing apples with apples. You may be able to get a much better rate. In fact, getting cheaper money on either the lease or the loan may change the economics completely. If you buy the $45,000 car we've been talking about, you'll pay sales tax of $5,400, for a total of $50,400. Financing over 48 months at 6 percent will produce a payment of $1,183.65 per month.
If you lease the same car over the same term, with a residual of $20,000, you'll make monthly payments of $687.13 plus 12 percent tax of $82.46, for a total monthly payment of $769.59. Buying the car with a loan costs a whopping $414.06 more per month than leasing the car over the same period.
I know what you're saying. But at the end of the loan, you'd own a car worth something like $20,000. At the end of the lease, you'd own nothing. What's better?
Okay, here comes the real left-brain weenie stuff. If you invested the $414.06 that you'd save every month by leasing rather than buying, what rate of after-tax return would you have to realize to have $20,000? That's the critical question, because if it's possible to earn at least that rate of return, leasing would be more cost efficient than buying. And the answer that you'd barely have to earn a return at all. If you put $414.06 into a cookie jar every month, you'd have $19,875 after forty-eight months. (Note: This is not a recommendation.) So conceptually, if we hold all the other variables constant, vehicle leasing is a better deal than a vehicle loan.
What about a lease versus all cash? That's really a question of opportunity cost. If you buy that $45,000 vehicle for cash in B.C., you'll pay $50,400 with PST and GST. At the end of 48 months, you'll have an asset estimated at $20,000, plus you'll have the value of saving the $769.59 per month that we would have been putting into lease payments.
If, on the other hand, you lease the vehicle, you'll pay $769.59 per month for 48 months and have nothing at the end of that term, but you'll have the value of saving the $50,400 that you didn't spend on the car. If you're paying a six percent after tax interest rate on the vehicle lease, you'll have to earn almost 11 percent after tax on your capital of $50,400 to make it worth your while to lease the car and invest the money. For most people, that will mean that all cash is the best deal. (For many small business people, though, money invested back into their companies can earn more than that.)
So there it is. All things being equal, cash is king, followed by leasing, and then buying with a loan. Although, naturally, all things won't be equal, and your mileage may vary. There. Isn't your left hemisphere happier now?
Source
By John Caspar
June 10, 2008
When you're in a new car mood, there are questions that must be answered. First among them, of course, is the question of whether or not you really need a new car at all.
In aggregate, new car purchasers discard their cars with lots of usable life still in them, so odds are you don't need a new vehicle. And environmental sensitivity may lead you to consider that a slightly less efficient older car that already exists is a lot better for the planet than manufacturing yet another car.
The thing is though, you want to buy one anyway because, darn it, you just feel like it. Now, your left brain hemisphere is fairly shrieking that buying a used vehicle is smarter, that keeping the old car is smarter, blah blah blah. All that analytical noise can be irksome when what you really feel like doing is getting a nice new shiny set of wheels with more horsepower, more airbags, and more cup holders. So what do you have to do to get rid of all that cognitive dissonance that might prevent you from getting the toy that you want? Occupy your left hemisphere (and perhaps your better half) with lots of analysis about car lease versus car loan versus (if it's an option) all cash. That's what this column is about.
This will entirely distract the weenie killjoy part of you, allowing the irrational side of you to have some fun and throw good money out the window. Hey, I'm here to help. And, of course, you can refer to this analysis even if you actually do need a new car.
First let's look at a vehicle loan versus a vehicle lease. When you buy a vehicle with a loan, you put down an initial deposit or down payment on the car, and pay the balance over a prescribed period. The set monthly payment you make includes both interest and principal components. When the term of the loan ends, you own the car outright.
When you lease a vehicle, you put down an initial deposit or down payment, and make set monthly payments over the term of the lease, just like a loan. The monthly payments, however, are not designed to retire the entire outstanding liability on the price of the vehicle. The leasing company makes an assumption based on experience that the vehicle will have a minimum value at the end of the lease term. That value is called the residual. The lease payment is set so that at the end of the lease term, there will still be an outstanding balance owing on the vehicle. That outstanding balance is equal to the residual value - what the lease company thought it would be worth.
Your lease payment, then, is a blend of principal and interest on the original price of the vehicle minus the residual, plus interest on the residual amount. If you leased a $45,000 car with a residual value of $20,000 after forty-eight months, you'd pay principal and interest on $25,000 ($45,000 - $20,000), plus interest only on $20,000. At the end of the forty-eight months, there would be $20,000 left owing on the car. Depending on the type of lease, you may or may not be at risk for any difference between the residual and the market value of the vehicle.
Vehicle leasing is very popular because the financing structure in a lease means that the monthly payment is lower than a vehicle loan of the same value. New car guys love it. I've been met at the door of car dealers with the line "What kind of monthly payment can you afford?" In terms of cash flow, leasing looks great. But what's a better deal really, a loan or a lease?
Tax advantages sometimes get talked about vaguely on the showroom floor of new car dealers. We'll dispense with such discussion here except to say that for the first couple of years, leasing provides greater deductibility, and over four years, it's a coin toss. Because most people can't deduct their vehicle costs or have more vehicles than are deductible, we'll ignore any comparative tax benefit a lease might provide to someone who traded a vehicle in every two years.
The biggest difference between a car loan and a car lease is the fact that the loan involves a purchase transaction, while the lease is a rental. For example, if you decide to purchase a $45,000 car in my home province of B.C., that purchase would attract a 12 percent sales tax - a 7 percent provincial sales tax, plus 5 percent in federal GST. Your total capital required to buy the car, then, would be $50,400.
When you lease a car, the car you are leasing still shows on the balance sheet of the lessor. No sale has occurred, so there is no sales tax levied on the purchase price. The car cost is $45,000, and that's what the lease is figured on. The sales tax you'll pay will be on the monthly lease payments.
Let's run some numbers for your left hemisphere. Let's assume that you put nothing down on either the loan or the lease, and that both the loan and the lease are done at an interest rate of 6 cent. (These assumptions are done just to make sure we're comparing apples with apples. You may be able to get a much better rate. In fact, getting cheaper money on either the lease or the loan may change the economics completely. If you buy the $45,000 car we've been talking about, you'll pay sales tax of $5,400, for a total of $50,400. Financing over 48 months at 6 percent will produce a payment of $1,183.65 per month.
If you lease the same car over the same term, with a residual of $20,000, you'll make monthly payments of $687.13 plus 12 percent tax of $82.46, for a total monthly payment of $769.59. Buying the car with a loan costs a whopping $414.06 more per month than leasing the car over the same period.
I know what you're saying. But at the end of the loan, you'd own a car worth something like $20,000. At the end of the lease, you'd own nothing. What's better?
Okay, here comes the real left-brain weenie stuff. If you invested the $414.06 that you'd save every month by leasing rather than buying, what rate of after-tax return would you have to realize to have $20,000? That's the critical question, because if it's possible to earn at least that rate of return, leasing would be more cost efficient than buying. And the answer that you'd barely have to earn a return at all. If you put $414.06 into a cookie jar every month, you'd have $19,875 after forty-eight months. (Note: This is not a recommendation.) So conceptually, if we hold all the other variables constant, vehicle leasing is a better deal than a vehicle loan.
What about a lease versus all cash? That's really a question of opportunity cost. If you buy that $45,000 vehicle for cash in B.C., you'll pay $50,400 with PST and GST. At the end of 48 months, you'll have an asset estimated at $20,000, plus you'll have the value of saving the $769.59 per month that we would have been putting into lease payments.
If, on the other hand, you lease the vehicle, you'll pay $769.59 per month for 48 months and have nothing at the end of that term, but you'll have the value of saving the $50,400 that you didn't spend on the car. If you're paying a six percent after tax interest rate on the vehicle lease, you'll have to earn almost 11 percent after tax on your capital of $50,400 to make it worth your while to lease the car and invest the money. For most people, that will mean that all cash is the best deal. (For many small business people, though, money invested back into their companies can earn more than that.)
So there it is. All things being equal, cash is king, followed by leasing, and then buying with a loan. Although, naturally, all things won't be equal, and your mileage may vary. There. Isn't your left hemisphere happier now?
Source
