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Leasing versus borrowing: evaluating alternative forms of consumer credit.

Leasing Versus Borrowing: Evaluating Alternative Forms of Consumer Credit

A straightforward method for evaluating lease versus borrow (buy) decisions facing consumers is presented and illustrated with actual financing cost data reported to new car purchasers. In general, individuals should consider the after-tax cash flows associated with alternative borrowing arrangements, the period of time in which these cash flows occur, and the opportunity cost of capital in order to identify the least costly financing alternative. The decision framework provided in this article can be used to make informed and intelligent choices between alternative types of consumer credit contracts.

A method of evaluating the lease versus borrow (buy) decision encountered in consumer financing transactions is discussed. This method is consistent with the principles of corporate financial theory, yet its content is accessible to individuals who may lack extensive training in the methods of analytical finance. In addition, the method is sufficiently general to cover a wide variety of individual circumstances and leasing arrangements.

While the framework presented here can be used to evaluate different types of lease versus borrow questions, the illustrations shown describe automobile leasing and installment purchase alternatives. Vehicle leasing has become an increasingly popular financing alternative for new car buyers. Recent data reported by the National Vehicle Leasing Association (NVLA) (Hinsberg 1988), an industry trade association, indicate that private new car leasing volume accelerated at an average annual rate of 24 percent between 1982 and 1987, reaching 750,000 leased vehicles in 1987. This total represented seven percent of the retail new car sales market. Moreover, the NVLA expects this growth trend to continue into the 1990s.

In many cases, consumers incorrectly select the leasing option because it offers lower monthly payments and a smaller downpayment than the installment purchase alternative. In other cases, consumers incorrectly select leasing to take advantage of the tax deductibility of lease payments. The Tax Reform Act of 1986 (TRA) significantly restricts this tax benefit, however, so that most consumers can no longer deduct vehicle lease payments from taxable income. Section 280F(d)(3)(A) of the TRA (1987) explains that individuals earning income as employees are not permitted to deduct any amount of personal vehicle lease payments (even if the auto is used in connection with taxpayers' employment) unless the vehicle is required as a condition for employment and used at the convenience of the employer.

Moreover, Section 163(h)(2)(A) of the TRA (1987) phases out the personal interest deduction associated with vehicle installment purchases. Only 40 percent of such interest is deductible in 1988, twenty percent in 1989, ten percent in 1990, and none thereafter. While business interest expense continues to be deductible according to the TRA, individuals performing services as employees do not constitute a business for the purpose of deducting installment interest payments. In most cases installment interest charges paid by consumers after 1990 will not represent deductible expenses.

Cash flow and tax consequences represent only two of the considerations necessary to make an informed financing choice. A review of all relevant attributes to consider when evaluating lease versus borrow alternatives and a logical framework to organize these attributes are needed to determine the optimal financing method.

THE LITERATURE

Lease contracts are frequently divided into two different categories: (1) financial leases and (2) operating leases. Most consumer lease agreements represent operating leases, while business leases are often identified as financial leases. For this reason the following discussion is restricted to operating lease contracts. Readers interested in the mechanics of financial leases can consult Brigham and Gapenski (1988) for a thorough introduction to this topic.

Operating lease contracts are frequently subdivided into two categories: (1) open-end leases and (2) closed-end leases. The open-end lease contains an option that allows the lessee to purchase the leased asset at the maturity of the lease. If the lessee decides to return the leased asset at lease maturity, however, the lessee may be required to make an end-of-contract payment to the lessor. This payment is required when the market value of the leased asset is below its estimated value reported in the lease contract.

In contrast to the open-end lease, most retail lease contracts represent closed-end operating leases. These contracts are popular with consumers because they do not contain an end-of-contract payment. Closed-end leases require a fixed number of payments for a specified number of months, and at the end of this payment period the lessee simply returns the leased asset to the lessor. When the asset is returned undamaged and without excessive wear, the lessee has no terminal financial obligation to the lessor. This is true even when the lease agreement is written to provide the lessee with an option to purchase the asset at lease maturity.

Although extensive literature exists on the question of leasing versus borrowing, the emphasis has been on financial leases; as Copeland and Weston (1982) note, these are dissimilar from operating leases. While Copeland and Weston provide one of the few rigorous investigations of operating lease contracts, this treatment is too complex for practical use by consumers, and it requires information that is typically unavailable to consumers. On the other hand, popularized articles discussing operating leases, such as one contained in Consumer Reports (1988), are oversimplified and can give only approximations regarding true leasing costs.

In the absence of a simple and accurate method with which to evaluate the lease versus borrow alternative, consumers may often focus on several different attributes when selecting the lease alternative. Hinsberg (1988) suggests that vehicle leasing is often preferred over an installment purchase because (1) lease financing often requires a lower downpayment and monthly payments than installment purchase, (2) leasing permits consumers to acquire more costly vehicles for a given monthly payment, and (3) leasing simplifies the disposal of used vehicles at the maturity of the lease. While these attributes might give the impression that leasing represents the least costly financing alternative, this impression is frequently inaccurate.

THE LEASE VERSUS BORROW (BUY) COMPARISON

Evaluating the lease versus borrow question can be accomplished within the framework of traditional financial analysis. The net burden imposed by alternative financing arrangements depends upon the incremental cash costs of different financing contracts, the period of time in which these costs are realized, and the borrower's opportunity cost of capital. This framework can accommodate various tax consequences encountered in the lease-borrow analysis, unequal contract maturities associated with different financing alternatives, and uncertainty regarding the future market value of the leased asset.

A common explanation for the growth in automobile leasing is that new car lease payments are frequently lower than the alternative installment loan payments required for vehicle purchase. This difference gives rise to a net cash advantage for leasing realized over the life of the lease. This advantage, however, is offset by differences in lessee-buyer wealth positions at the maturity of the different financing arrangements. Installment buyers acquire ownership of the vehicle following the final loan payment, while lessees surrender leased assets without compensation at the expiration of the lease contract. In fact, given the mileage and condition of the leased vehicle at the point of surrender, the lessee may be required to make a final adjustment payment to the lessor.

Given this difference, financial analysis identifies the particular rate of return necessary to transform the incremental cash advantage of leasing into the market value of the leased asset at the expiration of the lease. This rate of return, identified as the effective annual lease hurdle rate (K), represents the annualized return on invested cash flows that the lessee must earn to achieve total wealth equal to that of the installment purchaser at the time the lease contract matures.

The value obtained for K, in combination with market interest rates and investor risk preferences, determines the optimal financing alternative. If K is less than the after-tax rate of return that the lessee/borrower can obtain on invested capital, then leasing provides a greater total wealth at maturity of the financing contract. In this case the lessee can invest the net cash inflows derived from leasing at prevailing market interest rates, and this investment will grow in value over the term of the lease to exceed the expected market value of the leased asset.

When K exceeds the after-tax rate of return available to the consumer, the borrowing alternative is superior. In this case the future value of invested net cash inflows from leasing falls short of the vehicle's market value at lease maturity, so that the wealth of the vehicle owner exceeds the value of the lessee's cash investment.

In cases where K is equal to the after-tax returns available on invested capital, leasing once again represents the more desirable financing method. While this condition suggests that the future value of the lessee's invested capital will equal the market value of the borrower/owner's asset at lease maturity, the lessee's financial investment provides greater liquidity than the owner's vehicle. It is easier to convert financial assets to cash at their fair market value than to convert automobiles.

Calculating K requires specification of (1) the tax position of the lessee, (2) a set of lease contract conditions, and (3) a set of installment loan conditions. These data involve publicly available information that lenders are required to provide borrowers under the Truth-In-Lending Act of 1969 (1984) and the Consumer Leasing Act of 1976 (1984). For example, assume that both lease payments and installment interest charges are not deductible from taxable income. This second condition describes a vehicle leased for personal use, while the first assumption reflects the nondeductibility of consumer interest expenses imposed by the 1991 form of the 1986 Tax Reform Act.

Let D and S represent the initial cash outlays for the installment purchase and lease contracts, respectively. The initial cost saving provided by leasing is given by C, where C is defined as

C = [D - S]. (1)

Let [P.sup.t] and [L.sup.t] represent the periodic contractual purchase and lease payments in period t, respectively, so that the periodic cash savings derived from leasing is equal to [M.sup.t]. Variable [M.sup.t] is defined as

[M.sub.t] = [[P.sub.t] - [L.sub.t]], (2)

where there are n such payment differences as determined by the length of the lease contract. Finally, let [R.sup.n] represent the net residual value of the vehicle upon expiration of the lease, where this value includes the total residual value stated in the lease contract minus the lease security deposit returned to the lessee in period n.

The periodic lease hurdle rate, k, is established by solving

[Mathematical Expression Omitted]

for k. In most cases, lease and debt service payments are made on a monthly basis, so that k represents a monthly interest rate. This rate can be expressed as an effective annual lease hurdle rate, K, through the transformation

K = [[1 + k].sup.12] - 1. (4)

Equations (3) and (4) are adapted from the principles of financial mathematics used to construct loan amortization schedules and determine the effective annual percentage cost of installment credit. Solving equation (3) for k provides the monthly rate of interest at which the total cash advantage to leasing must be invested to increase over the term of the lease to equal the vehicle's residual value at lease maturity. A complete discussion of the financial mathematics applied here is contained in Cissell, Cissell, and Flaspohler (1986, pp. 105-130).

Equation (3) is useful for exploring how the calculation of the lease hurdle rate is affected by the expected market value of the leased asset at the termination of the lease contract. As [R.sub.n] decreases, reflecting more rapid vehicle depreciation, the lease hurdle rate decreases, and leasing becomes a relatively more attractive option. In the examples given below, [R.sub.n] is set equal to the asset's residual value obtained from the lessor, less the return of the cash security deposit required at the beginning of the lease. However, the value of [R.sub.n] can easily be changed to accommodate the specific depreciation characteristics expected from different automobiles.

The lease versus borrow comparison can also be modified to incorporate the tax deductibility of lease payments. After-tax leasing costs,

[S.sup.'] = (1 - t), and (5) [L.sup.'.sub.t] = [L.sub.t](1 - t), (6)

where t represents the lessee's marginal tax rate.

A simple numerical example demonstrates a specific application of the lease-borrow comparison. In conformity with the final form of the 1986 Tax Reform Act, this example assumes that both lease payments and installment interest charges are not deductible from taxable income. A recent new car sales promotion offered potential customers the choice between (1) a 66-month closed-end lease, or (2) a 60-month installment financing contract for a 1988 BMW Model 528e. The vehicle's cash selling price was reported as $31,560, its residual value at lease expiration was $12,500, and the installment financing contract required a cash downpayment of $6,312. Data reported for both the lease and installment financing contracts excluded sales taxes and licensing fees.

The cash flows corresponding to the offer are summarized in Table 1 under Example A. The value for S reflects the first month's lease payment made in advance, plus a refundable security deposit of $499. The longer duration of the lease contract relative to the borrowing contract results in a negative payment advantage to leasing in months 61 through 65 of $499. Finally, the net residual value in month 66 represents the lease contract residual value, reduced by the return of the lease security deposit [$12,500 - $499 = 12,001]. [Tabular Data Omitted]

The monthly lease hurdle rate, obtained by solving equation (3) for k, is 1.54 percent. This produces an effective annual lease hurdle rate of 20.19 percent, representing the minimum acceptable rate of return on the net cash inflows provided from leasing that automobile consumers must earn in order to justify the selection of the lease.

Of course, the validity of this analysis requires that consumers are able to invest periodic net cash flows at the 20.19 percent after-tax rate throughout the term of the lease contract. As market interest rates become increasingly volatile, the rates of return at which the incremental cash flows are invested will vary through time. In this situation, the appropriate investment return used to evaluate the lease hurdle rate should represent the average annual return that consumers expect to earn on invested cash over the life of the lease.

Table 2 shows how the effective annual lease hurdle rate (K) responds to changes in the residual value of the leased asset. In general, the lower the vehicle residual value, the lower the value of K necessary to equate the future value of cash inflows derived from leasing with the net residual value ([R.sub.n]), and the more attractive the lease option. When the BMW described in Example A retains only fifteen percent of its original cost at the maturity of the lease, the lessee would require a minimum 4.47 percent after-tax return on invested cash flows to justify the leasing alternative. In contrast, when 45 percent of the vehicle's initial cost is retained at lease maturity, the lessee must earn a minimum after-tax return exceeding 22 percent for leasing to be superior to the installment purchase. [Tabular Data Omitted]

A second brief example demonstrates that other lease-borrow comparisons yield strikingly different results from those shown in Example A. The leasing data provided in Table 1 under Example B describe special introductory lease terms offered by General Motors Acceptance Corporation (GMAC) for its "SmartLease" product. This four-year lease, described in GMAC Quest magazine (General Motors Acceptance Corporation 1988), requires 48 monthly payments of $222.58 to acquire an unspecified General Motors product with a cash selling price of $12,000. The residual value of the vehicle at lease expiration is given as $4,884, and the lease requires a $447.58 downpayment, representing the first month's lease payment plus a $225 refundable security deposit.

The leasing alternative is compared with installment financing terms requiring a twenty percent downpayment on a $12,000 vehicle, with the remaining principal balance financed over a four-year period. Given 48 equal payments of $245.71, the annual percentage rate of interest (APR) on this loan is 11.0 percent. The net residual value ([R.sub.n]) of $4,659 shown in Table 1 is equal to the vehicle's $4,884 residual value, less the return of the $225 security deposit. The monthly payment advantage to leasing ([M.sub.t]) in months 1 through 47 is $23.13, representing the difference between the lease and installment loan payments. In month 48, however, the leasing payment advantage rises to $245.71, because the final loan payment occurs in month 48, while the final lease payment occurs in month 47.

The effective annual lease hurdle rate (K) necessary to transform the net cash inflows attributable to lease financing into the net residual value ([R.sub.n]) at the maturity of the lease is 11.75 percent. In this case, consumers who are able to invest the $1,952.42 downpayment advantage provided by leasing ($2,400 - $447.58) and the monthly payment advantage to leasing described above at an after-tax rate of 11.75 percent realize terminal wealth of $4,659 at lease maturity. This cash investment is equal to the net residual value of the leased asset that must be surrendered by the lessee at lease maturity.

The substantial difference between the values of K obtained in Examples A and B is attributable to the relative cost of the lease versus installment financing contracts in each example. In Example A, the APR associated with the installment loan contract is only 7.14 percent. This makes the lease alternative described in Example A relatively less attractive, which is reflected in the high value for K obtained in the lease-borrow comparison. In Example B, the 11 percent APR of the installment financing contract makes the GMAC lease alternative relatively more attractive. This is reflected in the lower value of K obtained in this example.

CONCLUSION

While leasing has become an increasingly popular financing option in recent years, this option may not always be the most beneficial financing alternative for consumers. Ironically, accurate comparison of lease and installment purchase contracts is hampered by Federal legislation designed to inform consumers of the true costs of different financing options. The Truth-In-Lending Act of 1969 (1984) requires installment lenders to express the effective cost of borrowing in the form of an annual percentage rate, so that consumers can accurately compare the cost of alternative financing arrangements. Unfortunately, the Consumer Leasing Act of 1976 (1984) does not require lessors to report the effective cost of leasing in a form comparable to the APR. Therefore, simple and direct comparison of the percentage costs of lease and installment loan financing methods is not possible.

It is possible, however, to use the cash flow data reported to consumers by lessors and lenders to determine the optimal financing alternative. In cases where leasing results in lower cash outflows throughout the term of the financing contract, this cash flow advantage associated with leasing can be invested over the life of the lease contract. Comparing the value of the lessee's cash investment to the leased asset's net residual value at the maturity of the lease contract identifies the particular financing alternative that maximizes consumer wealth. These analyses demonstrate how the application of basic financial mathematics can help consumers make informed and intelligent choices in the selection of retail financing contracts.

REFERENCES

Brigham, Eugene F. and Louis C. Gapenski (1988), "Lease Financing." Financial Management:

Theory and Practice, 5th revised edition, Hinsdale, IL: Dryden Press: 581-604. Cissell, Robert, Helen Cissell, and David C. Flaspohler (1986), "Compound Interest,"

Mathematics of Finance, 7th revised edition, Boston, MA: Houghton Mafflin Co.: 87-164. Consumer Leasing Act of 1976 (1984), 15 U.S.C. [subsection] 1667a. Consumer Reports (1988), "Should You Lease Your Next Car?" (April): 216-218. Copeland, Thomas E. and J. Fred Weston (1982), "A Note on the Evaluation of Cancellable

Operating Leases," Financial Management, (Summer): 60-67. General Motors Acceptance Corporation (1988), "Introducing Smart Lease," GMAC Quest,

(October). Hinsberg, Claire M. (1988), "Leasing the Car of Your Choice," GMAC Quest, (February):

18-20. Tax Reform Act of 1986 (1987), 26 U.S.C. [subsection] 163 and [subsection] 179. Truth in Lending Act of 1969 (1984), 15 U.S.C. [subsection] 1601.

Bennie H. Nunnally, Jr. is an Asociate Professor and Department Chair in the Department of Finance and Business Law at the University of North Carolina - Charlotte, Charlotte, North Carolina, and D. Anthony Plath is an Assistant Professor in the Department of Finance and Business Law at the University of North Carolina - Charlotte, Charlotte, North Carolina.
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Author:Nunnally, Bennie H., Jr.; Plath, D. Anthony
Publication:Journal of Consumer Affairs
Date:Dec 22, 1989
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