Car Leasing

We recently had some foreign visitors staying with us. They commented on all the expensive cars that ply our streets. “Wealthy people!” they said. I replied that, to paraphrase Archie Bunker, people don’t buy cars here, they rent them. As long as you are rich enough to make a $400-500 monthly payment, you can drive a hot car. In other words, leasing is rampant in the auto industry, and that was borne out in a recent newspaper article.

Leasing represented 46% of new car transactions in 1997, compared to 14% in 1990. Ford Motors, for instance, saw as high as 70% leased, and more recently experienced 58%. An increasing number of people are turning their cars back in when the lease runs out and re-leasing a new vehicle. That’s an expensive way to get around. The monthly payments over the lease term implicitly cover the interest on the original value of the car plus depreciation over the lease term. Many lessees forget the old adage that a new car depreciates 30% when you first drive it around the block.

The accompanying table shows the undepreciated (“residual”) value over the decade as a percentage of the original purchase price for leases of varying durations (months).

years/months
24
36
48
60
1991
56.3%
1992
50.8%
41.3%
1993
49.9%
44.1%
35.5%
1994
58.4%
45.0%
39.1%
31.3%
1995
62.7%
53.8%
41.7%
36.8%
1996
62.6%
54.9%
48.3%
37.0%
1997
65.9%
58.0%
50.3%
43.6%
1998
62.2%
56.2%
49.4%
42.5%

For instance, the residual value of a two year old Ford Explorer sport utility vehicle has fallen from 61% a few years ago to 55%. SUVs had residual values as high as 80% even earlier.

If you are in the habit of entering a new lease every two years, you’ll spend your life paying for a lot of depreciation. A $35,000 car, for instance, would depreciate $13,300 in the first two years, but only approx $2,200 in each of the next two years.

The table also shows the trend since 1991. The residual values kept rising through the 1990s until 1998. The residual values rose because the slowdown in new car sales resulted in a shortage of used cars. That slowdown was partly due to general economic conditions and partly to “sticker shock” at the price of new cars. Things reversed in 1997 when new car sales took off and used prices fell from lower demand.

The tax breaks with leasing were often over-sold to an unwitting car buyer. Even consumer articles on the subject (unintentionally, I am sure) misrepresented the facts. The write-off of the lease payment compares to the write-off of interest plus depreciation. If you own the car for a long time, the timing differences between the two alternatives will wash.

If you are contemplating a lease deal, you must “get behind the numbers” of monthly payments, down-payments and residual values to see what the implicit interest rate is in the deal. This is your “cost of capital” and should be compared to other alternatives, including liquidating low-earning investments or obtaining bank financing. People who require financing assistance with their purchase are frequently enticed to leasing because it often has a lower monthly payment than the bank loan. But this happens because the bank loan principal will pay down completely over the loan term whereas the lease will have another cash call to buy out the residual value.

If you are able to deduct automotive costs for tax purposes, tax law exists to restrict the write-off potential on both purchased and leased passenger vehicles. Presently, only $30,000 (plus sales taxes) can be depreciated on a purchased car. For a leased one, there is a complicated formula to achieve essentially the same thing.

Thus, if you buy a $40,000 car, $10,000 is not tax deductible, ever! As a business-person, imagine choosing to make an expenditure that is only 2/3rds deductible!

Bear all of this in mind next time you’re in the market for a car.