Good Friday morning my friends!
I hope everyone’s first week of June was a banger (I learned this is a great word to describe something you enjoy from one of my favourite Peloton coaches, Ben Alldis). The scorching hot weather we had last week in Manitoba supposedly streamed through the continent and hit the United States — if this is the case in your region, rest assured, we also received some banger thunderstorms after all that hot weather.
I have a ton of vehicle leasing thoughts (spoiler: I’m a pretty big proponent of leasing a vehicle, especially in today’s economic climate) and I’ll make sure to float them your way over time.
This week, I want to talk about a simple vehicle lease payment calculation. The math is a tad more complex than just a bi-weekly payment, especially if you put in a down payment or bring a vehicle in for trade.
First, Understanding the Difference Between Leasing and Financing
It’s important to understand exactly what leasing really is: rent. By and large, if you’re leasing a vehicle, you’re renting that vehicle. A friend recently described it as a “vehicle subscription” — I think this is spot on.
Conversely, financing (or buying) a vehicle relates to actual ownership — you gain title to that vehicle and you pay for the purchase price by way of loan payments.
In a lease, you’re paying for your use of that vehicle. Put another way, you’re paying for the depreciation that takes place while you drive the vehicle.
In a financing arrangement, you’re paying for the entire purchase price of the vehicle.
(Please note: In the accounting world, most leases end up as finance or capital leases, whereby the lease is treated exactly the same as though you purchased the vehicle. Accounting speak is not appropriate for this conversation.)
Down Payments and Trade-Ins on a Lease
If you’re renting a vehicle (leasing), it’s appropriate to view your down payment as prepaid rent. By and large, when you write that $2,000 or $10,000 or $20,000 cheque at the beginning of the lease, you’re really just prepaying for your use of that vehicle.
Same goes for a trade-in — if you bring a vehicle for trade-in and your lease payments decrease as a result of the trade-in value, the equity you had in that prior vehicle simply goes into the calculation as prepaid rent.
It is imperative to note: Trade-ins and down payments on leases are not guaranteed to be there at the end of the lease. If you put $5,000 down to prepay your lease, in the end when you bring that vehicle back to the dealership (or buy it outright), that $5,000 won’t be there waiting for you. (At least, not usually, though it’s very easy to build equity in a lease. More on that another day.)
That $5,000 down payment is, in essence, an expense you are paying right off the top.
The Right Way to Calculate a Lease Payment
Now that you know exactly what a lease payment actually is (rent) and you know exactly what a down payment or trade-in actually is (prepaid rent), it’s time to put all the numbers together to correctly calculate your rent payment.
First, there’s the actual cash payment you’ll make either monthly or bi-weekly. Again, these are rent payments — these payments are pure expense and generally will not build your personal net worth. In a finance arrangement, each loan payment pays both principal and interest. The principal portion increases (or rather maintains) your personal net worth. Not so in a lease — the payment is pure expense.
Second, there’s the prepaid rent that you need to amortize over the life of the lease. So, if you have a 36-month lease on a vehicle and you put $5,000 down, that $5,000 payment is effectively decreasing each of your 36 lease payments. To calculate the amortization, simply calculate $5,000 / 36 = $138.89 — each lease payment is $138.89 less than the payment would have been had you not put any cash down. (Remember, this is approximate — there is always a little interest component in a lease, but I think the impact here is irrelevant given there is interest in a financing loan arrangement as well.)
So the formula for your actual expense for that lease is:
Lease expense = Lease payment + amortization of down payment/trade-in.
Here’s an example:
Say you’re going to lease a $50,000 vehicle with a $30,000 buy-out over 24 months and you are set to trade-in a vehicle worth $15,000. In a lease arrangement, you’re only paying $20,000 for your use of that vehicle, and you’re trade-in amount of $15,000 prepays your lease. This leaves only $5,000 to pay off in your lease payments over 24 months.
You’re going to see a very, very low lease payment every month — probably as low as $200 per month.
$200 a month to drive a $50,000 vehicle, you say?! That’s super cheap, right?!
You also have to add in the amortization of that $15,000 trade-in you brought to the table. $15,000 / 24 months = $625/month.
The actual cost of that vehicle is now $200 + $625 = $825/month.
That is a steep, steep increase, and is something you need to watch out for if you’re ever looking to lease a vehicle.
In order to ensure you maintain that original equity you put into the lease, you should put $625 a month into a separate savings account that acts as your “Vehicle Savings Account”. Once that 24-month lease is over, you are likely to have some equity built in the lease and you’ll have $15,000 in a savings account ready to go for the next lease or purchase.
To be clear, I’m a pretty big proponent of leasing a vehicle — leasing vehicles decreases the cash cost of owning a vehicle and leaves more cash in your bank account to build income-generating assets. It’s also quite difficult to be underwater in a lease (simply don’t drive more than your mileage allowance!) and it’s pretty easy to build equity in a lease. In the end, if you handle it correctly over a long period of time, leasing and buying work out to the exact same result.
(Which makes sense — if there was an obvious answer to this, then everyone would either buy or lease, whichever was the obvious answer.)
Nevertheless, it’s important to understand the true cost of a lease payment. Calculating the expense of a vehicle lease requires you to amortize the down payment over the life of the lease. This will bring you to a true number and aid you in deciding whether to lease the vehicle or to continue driving what you have.
If you successfully save the amortized amount in a savings account for your next lease, you’ll always have cash to put into your next lease or purchase. Easy, peasy.
As the restrictions in Manitoba relax ever so slightly this weekend, I wish you all a safe and fun weekend with your closest family and friends outdoors.
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