The first time I went to buy a car, I had saved enough to pay cash. However, I let the salesman talk me into financing it with a line that in retrospect makes no sense: “The car is a depreciating asset – you should always finance depreciating assets.” This type of line is just one of the misleading ways of thinking about buying a car that drives up costs – and dealer profit margins.
The biggest myth is that it is the monthly payment that matters, not the cost of the car or the interest rate or any of the other variables that determine the monthly payment. Just think of all the people that you know that are underwater on their car loans – if they sell the car they won’t get enough to pay off the loan. If they need to sell the car, or it gets totaled, they are in the unfortunate position of having to kick in cash to pay off the loan after the car is sold or disposed of. Chasing the lowest monthly payment was not enough to avoid an unpleasant situation for these consumers. Many are surprised to find that the exact same problem can happen with a leased car, especially if it is totaled – they then have to repay the full value of the car.
When most companies need to buy an asset, they look at it from a cash flow perspective, and figure out how much that asset is worth to them, through increased sales and/or cost savings. They use that calculation to evaluate the price of the asset. The decision of how to pay for it – what we used to call the financing decision – still hasn’t entered the analysis. If the asset will drive enough positive cash flow, taking into account taxes, maintenance costs and all the other variables, to earn a reasonable return on the original purchase price then it makes sense to buy it.
The financing decision becomes another way of maximizing the value to the company. The company will do the analysis of what is the most advantageous way of financing it – with accumulated cash, by borrowing or by leasing. Since the reasonable return is set using the company’s cost of capital (or the cost of raising funds), by definition that reasonable rate of return should be higher than the cost of capital.
For a consumer, determining the correct price of an asset such as a car is a much more subjective process, and involves value judgments as well as affordability. However, the lesson from big companies – keep the price setting separate from the financing decision – is still important. The consumer should negotiate the price of the car independent of financing and trade-in values. Once that is done, then financing options can be considered.
One of the more important things is to keep the length of time consistent between the options. For example, if you are evaluating a 5 year car loan versus a 3 year lease, make sure your analysis includes the benefit of selling the car at the end of 5 years. For the lease, the analysis should be run two ways: assuming that the purchase option is exercised, and then the car is sold at the end of 5 years, or that the cost of a new car at the end of three years is included. The monthly costs of the various option should be plugged into a standard finance model (the NPV function in Excel works fine for this), and the present value of the cash flows should be compared. The lowest cost option wins. If you aren’t comfortable with this type of calculation, ask a friend who is financially more sophisticated to help.
In addition to the term of ownership being consistent, it is also important to set the starting purchase price the same. “But in a lease you are not buying the asset, so the number we put in that box on the computer doesn’t matter,” the dealer might say. Of course it matters! Tell the salesman to re-run the model with the negotiated price and watch the monthly payment go down. Using the MSRP for the purchase price becomes a way for the dealer to get paid the full MSRP by the bank (who ends up owning the leased car) rather than the amount you negotiated. Since few consumers challenge the starting value (after spending all that effort negotiating a price), is it any wonder dealers try to get consumers to lease a car?
Another common misperception is that leases don’t have an interest rate. Ask about the money factor built into the calculation – that is just another way of showing the interest rate. Technically, the money factor is the interest rate built into the leased divided by 2,400. However, what really matters is what interest rate you could borrow money for outside of the lease. It is pretty straight forward to calculate the interest rate built into the lease from your perspective (the money factor is based on the interest rate from the bank’s perspective, and there are a few differences that you don’t need to get hung up on).
I hear all the time that the good resale value of a given car creates lower monthly payments in a lease. Guess what? That good resale value benefits you if you buy the car, too. Most people never take into account the value of the car at the end of the time they expect to own it when they figure the costs of owning a car – creating an artificial advantage for the lease option. To make the calculation easier, I will often use the residual in the lease for all of the options being considered (assuming that the lease covers the full term of ownership).
Overall, the important lesson is that the value of the car is independent of how it is financed. Knowing that, you can then evaluate each financing option with the same asset value and the same assumed ownership term and final value of the car. From there, the analysis of which option will give the lowest overall cost over time is easily calculated.
Jonathan Buckley is a Fee-Only Financial Planner based in San Ramon, CA. His firm caters to ordinary, middle-income clients in the San Francisco Bay Area - people who usually would not have access to affordable, professional, objective financial advice. Jonathan's website is at Buckley Financial Planning |
|
