Smart Buying Essentials

Finance Costs

Including:

• Pay Cash or Take Out A Loan?
• Zero-percent Financing
• Sources for Loans
• Monthly Payments vs. Interest Expense
• Finding Yourself "Upside Down"
• The Cost of Leasing

Finance Costs

It is now time for a very brief accounting lesson. When we talk about finance costs, it is important to distinguish between what is actually a cost and what is not.

Let's say you bought a new car for $19,000. You no longer have the money, but you do have a car of equal value - an asset. If a bank loaned you $19,000 to buy the car, you owe the bank that money, but it still hasn't cost you anything. However, when you borrow money from any lending institution, not only will the lender ask you to pay back the money they loaned you, but they will also charge you interest. The money that they loan you is not a cost - the interest charge is. The lesson continues...

Pay Cash or Take Out A Loan?

For most car buyers, the answer to this question is easy: Let me sign those loan docs! If they want a new car, they'll have to borrow to the hilt to get it.

But, what if a buyer has a choice: to pay cash or to take out a loan. Let's say that Debbie Debtor and Kris Cash each buy a $20,000 car, and each has exactly $20,000 in the bank. Kris pays cash for her car. Debbie puts 15% down, finances the $17,000 difference with a 48-month, 5.75% loan, and puts her $17,000 in a bank earning 3.5% interest. She withdraws $379.62 from the bank each month to pay her car payment, which leaves her with a bank balance of $0 after 48 months.

Kris doesn't earn any interest on her money, but didn't pay any either, so she has a net cost of $0. Debbie must pay $397.30 each month in car payments, but she can take out only $379.62 each month from her bank account (or else she would deplete her bank account before 48 months). She has to pay an additional $17.68 per month for 48 months, or a total of $848 more than Kris.

Another way to look at it is that Debbie will pay $2,070 in interest over the 48 months, but will earn only $1,222 on her money in the bank, a difference of $848. To make matters worse, Debbie will probably pay income tax on the $1,111 that her money earned in the bank.

It used to be that Debbie could deduct her interest payments from her income taxes, which could have made her come out ahead of Kris, but these interest deductions are no longer allowed.

The bottom line: as long as the after-tax interest rate on the car loan is more than the after-tax interest rate that you could earn on your money, paying cash is less expensive than taking a loan.

Zero-percent Financing

No-interest loans are a relatively new wrinkle - one that few experts expected to last more than two or three months after the terrorist attack in New York City on September 11, 2001. But the scheme was so successful in luring buyers back into showrooms after the attack that automakers have found it hard to give up this persuasive marketing tool.

Consumers have become accustomed to attractive rates and big incentives to pull them in to dealerships, with showroom traffic slowing when automakers pull back on the aggressive financing. As import brands continue to grab larger market share, the Big 3 remain committed to these financial lures. Even significant, new products have been carrying incentives shortly after introduction, such as the Chrysler Pacifica and Ford F-150.

No-interest loans are clearly a good thing for buyers, removing the finance charges for a loan and enabling consumers to buy more car for the money. Compared to a loan with an interest charge, a no-interest loan can save you thousands of dollars. And if you're fortunate enough to be Kris Cash, as in our previous example, you can sign up for a no-interest loan to buy your car and keep your cash to earn interest from an investment.

But be warned: Deeply discounted loans may not apply to the hottest-selling models. And perhaps more important, only about half of all shoppers qualify for zero-interest or extremely low-interest loans. These loans typically require strong credit ratings. That leaves the other half of new-car shoppers who need loans looking for more traditional financing.

Sources for Loans

• Borrow from a dealer.

  If you can qualify for an automaker's discount financing offer, then the dealer will help you arrange the loan. And even if you can't qualify for a discount loan, a dealer can still offer convenience in arranging for another loan; at some dealers, it typically takes less than 30 minutes to obtain a loan. You can obtain financing and buy your car all in one stop.

  Dealers are also more likely than banks to qualify buyers with shaky credit ratings. And the lending arms of Ford, General Motors, and other automakers usually have plans to help customers with special needs. There are "first-time buyer" and "college-graduate" plans for those with no credit ratings. Ford Motor Credit can even set up a flexible payment schedule to accommodate teachers who receive pay checks only nine months out of the year.

  And the downside to dealer financing? Dealers obtain loans for their customers through local banks and finance companies, as well as through the automakers' lending arms. Dealers may add a bit to the interest rate over what they pay for the loan, keeping the difference as profit. Persuasive dealers working with uninformed buyers can make as much off financing a new car as they can on the car sale itself.

• Borrow from a bank, credit union, or finance company.

  In contrast to obtaining a loan through a dealer, borrowing from a lending institution tends to be haggle-free. Lending institutions usually offer set, nonnegotiable loan rates. And they're less likely to push credit life insurance-an unnecessary, expensive frill. Compared to banks and finance companies, membership credit unions typically offer the lowest interest rates. Finance companies are often the most expensive.

• Borrow on a home-equity loan.

  Transforming a part of your home's value into a new Mustang has one great advantage: Unlike the interest on a car loan, the interest on a home equity loan is usually tax deductible. If you're in a high tax bracket, you can save as much as 38% or so on interest costs by buying a car with the proceeds from a home equity loan.

  The danger is that your house, not just your car, is on the line if you can't make the payments. Moreover, revolving credit lines based on home equity require you to make payments of only interest, not principal. If you don't have the discipline to pay the principal you could easily end up with a depreciated car worth little or nothing and a huge loan against your house. In addition, start-up costs-including property appraisal, title search, and lender points-can be substantial if you don't already have a home-equity credit line.

• Borrow on investments or insurance.

  If you own a large portfolio of securities, a passbook savings account, a 401(k) savings account, or a cash-value life insurance policy, you may be able to borrow against them at attractive interest rates with flexible - or even no - repayment plans. But with any of these loans, you're hocking some element of your future. If there's a margin call against your security loan, you might be forced to sell your stocks and bonds at a big loss. Or if you died while your insurance-policy loan was outstanding, the proceeds to your family would be reduced by the loan amount.

• Striking a Balance: Monthly Payments vs. Interest Expense

  Determining the cost of a loan is inherently complex. There is a myriad of terms that affect the final cost of the loan. Through it all, a few simple truths exist:

  • The higher the interest rate, the higher the monthly payment.
  • The more you borrow, the higher the monthly payment.
  • The longer the period of your loan, the lower the monthly payment.

  In each of these cases, the cost of the loan will be higher. While the first two points are fairly intuitive, the third point catches a lot of people off guard. A salesperson will frequently attempt to lower your monthly payment, sometimes quite substantially, by stretching out the loan period. But, buyer beware, this will ultimately cost you more. For example, the monthly payment on a $15,000 loan at 8% for five years is $62 less than the same loan over a four-year period. However, the total interest expense is $672 more for the five-year loan versus the four-year loan. This is the cost you pay for the privilege of stretching out your payments for one more year.

Finding Yourself "Upside Down"

Nowadays, it seems you have to pay as much for a new car as you did a few years ago for a house. But as new-car prices rose dramatically in recent years, lenders found a clever way to allow people to continue to buy new cars - they simply extended the length of loans, thus keeping monthly payments affordable.

In the past, 24-month or 36-month car loans were the norm. But today, 60- and even 72-month loans are common. With the longer loans, however, it takes longer to reach a positive equity position in a car and owe less on it than it's worth. As soon as you drive that shiny new car off the dealer's lot, the car plunges in value - thanks to that ol' devil depreciation. But with a shorter length loan, after a year or so of making payments, your car's value will be worth more than you owe on it. Until then, you're "upside-down," as they say in the auto business.

With longer loans however, you could be upside down for two, three, or four years. It typically takes 40 to 42 months to build equity in a car if you put 20% down and have a 60-month loan. And therein lies the rub: If during that time you want to trade in your car on another one, you'll be in the frustrating situation of owing more on your old car than it's worth, thus making it all the more expensive for you to buy the newer car.

So if you must take a longer loan in order to lower the monthly payments on the car you really want, plan on keeping the car for nearly the life of the loan or more. If you can't keep it that long, be sure to choose a car that holds its resale value well (See Vehicle Charts) because that will reduce the time it takes you to reach a positive equity position.

The Cost of Leasing

No question about it, leasing has advantages over buying. For one thing, you usually don't have to come up with as large a down payment when you lease. With the price of the typical new car these days exceeding $20,000, the usual 20% down payment can amount to a hefty sum. And, if you're in the market for really expensive machinery in the $50,000 to $100,000 range, you're looking at tying up $10,000 to $20,000 in cash just for the down payment.

Aside from the difficulty of coming up with substantial cash to put down, some people don't want to pull their cash resources out of particularly lucrative investments to buy a car.

But perhaps leasing's biggest advantage is that your monthly payments will be lower than if you take out a loan. Here's why: When you buy a $30,000 car, for instance, you make loan payments based on that price (minus the down payment). But when you lease, the payments are lower because the car won't be yours when the lease is up. In other words, you'll only pay for part of the car. A $30,000 car might still be worth $14,000 at the end of a 36-month lease. So the leasing company would base your monthly payments on the depreciated $16,000, not the entire $30,000.

Or, by the same reasoning, you may be able to drive a more expensive leased car than you could afford to buy with a loan. Because you're not paying for the whole car with a lease, but only on the depreciated amount, the monthly lease payment on a $40,000 car could well be the same as a monthly loan payment on a $30,000 car. But there are still other advantages to leasing. At the end of the lease contract, you can walk away from the car and let the leasing company have the headache of reselling it. If you like to drive a new car every two, three or four years, trading in one leased car for another is very easy.

In some states, you may be able to save on sales taxes with a leased car. When you buy a car, you'll pay a sales tax on the entire sales price up front. But when you lease, you'll pay a sales tax on each monthly payment. And because as we've said before, you'll only be making payments on the depreciated portion of the car, you'll only pay sales tax on the depreciated portion rather than the entire value of the car.

If you use your car for business, you may also be able to deduct more from your taxes on a leased car. When you lease a car and use it only for business, you can write off nearly the entire amount of the lease payment, even on high-priced cars. By contrast, when you buy a car, there are limits on how much you can write off each year. On high-priced cars, it can take eight, ten or more years to fully depreciate the car for tax purposes. The leased car, especially one with a price tag of $20,000 or more, can give you more sizable tax deductions if your car is a legitimate business deduction. (Consult a knowledgeable tax accountant.)

For example, let's say you buy a $35,000 car and use it exclusively for business. The government will allow you take a maximum of $3,060 in depreciation for the first year of service, $5,000 for the second year, $2,950 for the third year, $1,775 for the fourth year, and $1,775 for every year there after, until it is fully depreciated. If you keep the car for four years, you'll be allowed a total of $12,785 in depreciation. But if you lease the same $35,000 car and your lease payments are $525 a month, you'll be able to write off $25,200 (48 X $525) over four years, or nearly twice as much.

No down payment, lower monthly payments, no resale hassles, possible tax savings - these are nice advantages but, unfortunately, they're not the end of the leasing story. As a rule, leasing usually costs more than buying a car outright with cash. Moreover, leasing a car is almost always more expensive than buying it with a loan (see Figure 5). At the end of the lease, you have nothing to show for all those monthly payments except memories and gasoline credit receipts jammed in the glove compartment. However, there are a few exceptions to the rule. If a manufacturer-subsidized-or sub-vented lease offer is available, leasing will be less costly than financing a purchase. Subsidized leases very often have net interest rates several percentage points below the APR for a loan.

However, automaker-subsidized leases are harder to come by than they were several years ago. Automaker lending arms, banks and other financiers lost too much money on subsidized leases in the late 1990s, and have since eliminated many of the sweet deals. Or, if you have some surefire investment that will pay a very high return for your cash, leasing may be less costly. But in these days of 1 or 2% money market rates, few of us have such high paying, risk-free investment opportunities.

Leasing may also be less costly if you can use what cash you have to pay off existing high-interest loans - credit card balances at 16% interest, for example - instead of putting the cash into a new car. But there are some special financial pitfalls to leasing. If you're leasing for the first time, you'll probably have an old car to trade in to the dealer. Your equity in your trade-in will serve as a down payment - or in the vernacular of leasing, a "capitalized cost reduction" - to reduce your monthly lease payment. But keep in mind that because you'll end up owning nothing when your lease is up, you won't have a trade-in the next time around. And that means you may face a substantial jump in your payments on your second leased car unless you can come up with a cash down payment. And having to come up with a big down payment defeats one of leasing's advantages. The "no down payment blues" is becoming more of a problem in the auto industry now that increasing numbers of people are winding up their first leases and thinking of moving into second ones.

Then there are possible mileage penalties. Most folks drive around 15,000 miles a year. But many leases - especially heavily advertised lease deals with attractive monthly payments - provide for only 10,000 or 12,000 miles of use per year. And for each mile you drive over the allotted amount, you'll pay a penalty - typically 12 to 15 cents, though it can be as high as 25 cents for some luxury cars. That means you'll be presented with a $1,000 to $2,000 bill at the end of a three-year lease. You often can negotiate a lower extra-mileage penalty upfront if you anticipate that you'll be driving extra miles. Even so, leases are much less likely to be cost-effective for those who drive more than 15,000 miles a year.

The same goes for people who don't take excellent care of their cars. Though leases do of course make provision for some wear and tear, they are written with the understanding that you'll follow the manufacturer's maintenance recommendations and that you'll return the car in good order. If you don't, the dealer could present you with yet another lease-end bill - this one for repairing dents or torn upholstery. The question often becomes a matter of what constitutes excessive wear. Some automakers are addressing the issue by attempting to specifically define damage. Ford dealers have loose-leaf binders with photos illustrating normal and excessive wear. Mercedes-Benz dealers will disregard a dent or scratch if it's no larger than a credit card. But in any case, if you tend to be cavalier about your car's upkeep, leasing probably isn't right for you.

Nor will it be right for you if there's any chance that you might try to get out of your lease early. When you lease, you are - in essence -paying for the car's expected depreciation during the term of the lease, plus an interest charge. Though your lease payment is the same each month, depreciation is not; a car depreciates more early in its life than it does later on. So when you end a lease early, you haven't paid your full share of its depreciation, and leasing companies will expect you to make up the difference - and pay an early termination fee besides. Altogether, early termination charges can amount to much more than the remaining balance of lease.

In summary, leasing does have advantages for some motorists - as long they look beyond the lower monthly payments and consider all the potential costs.