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I’VE BEEN KNOWN to overanalyze decisions, especially financial ones. When faced with a money question, often my first thought is to create a spreadsheet. While this brings groans from family and friends, I find them a great way to clarify my thinking and gain insights. Sometimes the resulting insights are glaringly obvious, and I get to laugh at myself.
My wife and I were looking to replace her nine-year-old SUV. We had read and heard that new car inventory was the biggest problem we’d face, and boy was that right. Even tried-and-true cars that have been around for decades were tough to find.
The dealer we went to had three of our desired SUV, each with a different trimline. One was the version we were interested in, but not the color we preferred. There was no negotiating on price. We test drove the model we were interested in, but took a day to decide whether we could live with the color. I called and asked for a price.
The dealer sent me a link to a great website, which showed the detailed pricing, our trade-in value and final cost. The site also had several tools to allow us to investigate financing or leasing the car. We could evaluate different lease periods and mileage allowances. Based on our inputs, the site told us the monthly payment and residual car value. The residual value is the price we’d have to pay if we wanted to purchase the car at the end of the lease.
I understand many people pick a car based on what they can afford per month and structure the purchase or lease accordingly. But me being me, I had to evaluate all the options to see which was the best deal. The three options I considered were: buy the car for cash, finance some of the cost, or lease the car for three years and then purchase it. So off to Excel I went.
It seemed like a pretty straightforward series of present value (PV) calculations. These involve turning all costs into a single price that’s expressed in today’s dollars. PV calculations are based on the notion that, given a choice, we’d rather pay $1 later than $1 today, because in the meantime we could use the money to earn interest. Excel makes it easy to do PV calculations.
The manufacturer was offering 0% financing for 48 months. To evaluate the financing option, I added the money we’d put down, plus the trade-in value, to the PV of the 48 monthly payments. This total could then be compared directly to the cash price.
Evaluating a lease is a bit more complex. I took the money due at signing (again, including the trade-in value) and added it to the PV of the monthly lease payments. To make the three options consistent, I assumed we’d buy the car at the end of the lease, so I also calculated the PV of the residual car value. The total of these present values could then be stacked up against the cash option and the financing option. My goal: Find the lowest PV.
As expected, the lease was the worst deal. The PV of that option was about $2,100 more than the cash option. The financing option was the best. Its PV was $253 less than the cash option. In retrospect, this should have been obvious. Free financing, with no hidden fees, is always better than tying up your own money.
After running the numbers on the three scenarios, I realized there was a fourth option to consider. In the scenarios above, you ended up owning the car. But many people lease a car and then turn it back in at the end of the lease. Why? Their employer might be paying for the vehicle, or perhaps they couldn’t afford to pay the residual value, or maybe they just like having a new car every few years.
In this fourth scenario, figuring out the cost of the lease is easy—you once again just add the money due at signing to the PV of the series of lease payments. But since you aren’t buying the car, this isn’t an apples-to-apples comparison to the first three scenarios. After thinking about this, I realized that instead of owning the car at the end of the lease, what you have is the money you didn’t spend buying the car. That, in effect, gives you the same PV as the leasing-and-then-buying scenario. My conclusion: The extra $2,100 you pay is for the privilege of leasing for three years and then having the choice to buy or not buy.
For those currently nearing the end of their car’s lease, that flexibility might be more valuable than usual. My sister-in-law’s high-end SUV just came to the end of its lease. She had intended to lease a newer version of the same vehicle but couldn’t find one that was available. That prompted her to look at buying her current SUV for its residual value. It turns out that the car’s current market price was significantly higher than the residual value, so she went ahead and bought it. What if it’s the reverse situation—and used car prices have softened? A friend told me that several years ago he was able to negotiate $2,500 off the residual value when there was a large supply of his model on the used car market.
Still, most of the time, leasing will likely be the least attractive option. In running the present value calculations, I assumed a discounting interest rate of 0.4%, which is the current rate on my FDIC-insured online savings account. If I can find a higher safe return for this money, the financing option looks even better. What would it take for the lease option to look better than the cash option? I’d need to be able to invest my cash at a safe 4% a year—an impossibility these days.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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