Lease/Ballooon loan versus Conventional loan. A real eye opener (must read)!!!!

[GTakacs]

Disclaimer: This post and the numbers are my opinion only and should nt be taken as legal advice as everyone's situation is different and requires their own unique calcualtion. Also just to get the terminology right: Premiere Purchase = Balloon Loan = Buyer's Option, which is very similar to lease in terms of payment amount per month for a vehicle for a specific term.

I was asked by an AudiWorld member if premiere purchase makes any sense now that the interest rates are so low on the conventional auto lonas, namely 1.9%. So for an example I have put together a fictional cash-flow estimation just so people will see how good Premiere Purchase can be. If you're doing a conventional loan you might be kicking yourself in the head after reading this......

For people who carry a fair amount of debt, it's better to keep their cash flow higher by using premiere purchase and use the extra cash to pay off higher interest credit cards or such.

For an example (these are fictional numbers just to demonstrate the idea)

Let's say you're buying a car that costs $30K out the door and has an MSRP of $31K. It also has a residual value of 48% after 48 months. We assume 1.9% interest on the conventional financing and 2.25% on the premiere purchase. We also assume that you owe $20K in credit card debt that carries a 15% interest.

Your total monthly budget is $1000 for the car payment and the credit card.

Scenario #1, conventional loan:
You take the conventional loan for 48 months.

With the conventional loan for 48 months on $30K with 1.9% interest, your monthly payment is going to be $650.
So from your $1000 budget you can spend $350 a month on the credit cards while $650 goes to car payments.
After 48 months you will have a car fully paid that will worth about 48% of it's orignal cost (that is the residual value), that means you will have a car that is worth $14,880.
During the 48 months you'll be making $350 a month payments toward your credit card debt that carries a 15% interest rate. After 48 months you will still carry a total credit card balance of $13,500. So your net worth will be the $1380 ($14,880-$13,500).

Note that the above assumes that the car would actually worth that much (it probably wouldn't) and the interest on the credit card is compounded monthly (it is actually compounded daily) so the actual figures would be even worse.

Scenario #2
You take the conventional loan for 60 months at 1.9% and we'll see what you're doing after 48 months.

With 1.9% for 60 months on $30K, your monthly payments on the car would be $525. That would leave you with $475 for your credit card payments. Let's see how you'd be doing after 48 months.
You'd owe $6,200 on your car after 48 months, and it would worth $14,880, making it a net value of $8,680 ($14,880-$6,200) to you.
On your credit card, after making 48 consecutive payments of $475, you would still owe $5,300. So you would have a total net worth of $3,380 ($8,680-$5,300)

Scenario #3
You do a premiere purchase with 2.25% on the $30K car for 48 months. With the 48% residual value your monthly payment on the car is going to be $360. That means that you can pay $640 towards credit card debt every month.
Making $640 a month payments on the credit car will actually pay off your $20K balance in 40 months. So for the last 8 months, you could be saving that $640 in a savings account. After 48 months your car will have no value to you as it will worth exatly as much as you owe on it, that is what premiere purchase is all about. However you will have 8 months of $640 saving saved up. So your net worth will be $5,120.

So looking at the above 3 scenarios which would you rather have?
1) $13,500 in debt on a credit card with a car that is fully paid for and chances are it is not worth as much as you thought it would?
2) $5,300 in debt on a credit card with a car that has $8000 equity in it that if you would decide to trade in you could probably get $6K out of it.
3) Absolutely no credit card debt, over $5,000 in the bank ready for a nice little down payment on a new car or a house and you are ready to take out a new loan for a new car since your 4 year old vehicle that just lost all its warranty is no longer worthwhile to keep.

I can assure you that the above numbers add up jut perfect, there is no magic involved. Also, the equations work with different interest rates and residuals just as well, and instead of credit card debt you can do a high yield investment on your extra money (if you're one of the lucky ones with no credit card debt).

The breakeven point depents on the interest rates offered on your investment/credit card and the difference between the conventional loan interest and the premiere purchase interest rate. With the current interest rates you would be crazy to tie up your money in a car doing a conventional loan. As the old saying goes:"Buy what appreciates, rent what depreciates".

Also I must add that with the premiere purchase you can still refinance your vehicle after the 48 months if you decide to keep it, you can sell it for a profit if the residual value (payoff balance) is lower than the market value, or you can just turn it back in if the market value is less than what you owe on it (most likely scenario, the used car market sucks at the moment, I doubt that it will get better within the next 4 years)

I hope this was an informative post and you can make a better educated decision regarding your finances. For me, getting premiere purchase is a no-brainer, would not consider any other option.

[GTakacs]

Addendum: What if I don't have debt? Is buying still a bad option?
Just as I wrote on the bottom of the post if you can find a good yield on your money then it might be worthwhile to invest instead of tying up your money in a vehicle that depreciates.

For my $30K car example, if you do a 48 month loan versus a 48 month premiere purchase with the 1.9% versus 2.25% and 48% residual value, you'd be saving $290 a month on monthly payments. If you invest it in a monthly compounded investment that has more than 3% yield, you are still better off doing the premiere purchase.

That way after 48 months you'd have $14,880 ($290x48 at 3% APR) in the bank that you could use to pay off the vehicle if you wanted immediately as the premiere purchase is up, or you can just turn the car back in and get another one while your trade in is guaranteed at $14,880 (that is what residuals are for). Yet if you just wanted to sell your car that you financed the conventional way, if you could not get $14,880 for it you'd be already losing money (and I pretty much guarantee that you would not be able to sell the car for the residual value). And $14,880 in the bank is a LOT better than tied up in a quickly depreciating asset such as a vehicle.

And all of this still didn't include the chance of an unfortunate event when your car gets totaled after 2 years of ownership.

For that illustration I just quote a post that I posted earlier regarding cap reduction on leases. The same applies here with different numbers (it's late and I don't want to re-run those numbers tonight, but you will get the point)

Let's say you buy a car for $25,000 and you either put nothing down and lease for 48 months for $323/month or you put $5000 down and lease for 48 months for $211/month.

The difference between the two monthly payments is $112 which seems like a lot. Multiply that by 48 months (number of payments) that is $5376. So you will end up paying $376 more over the term of the lease by not putting anything down and keeping your $5000 in your pocket. I am not going into details that you can actually earn interest on that $5000 and keep taking $112 out of it every month making the $376 difference even less, or that you could have used the $5000 to pay off a higher interest debt with it.

So if nothing goes wrong with your car during the term of the lease you will be out of $376 more by going this route. that is about $8/month (not counting other interest earning possibilities on your $5000).

Now let's look at the other scenario when your car gets totaled or stolen after a year. After 1 year that car will worth about $20,000 due to depreciation. If you paid no money down, after the first year your payoff would be about $22100. If you put no money down up front then you insurance will pick up the gap (GAP insurance) between what the car is worth ($20,000) and what you owe ($22,100). So the gap insurance will pay $2100 while the rest will be paid by the regular car insurance. You walk away clear and free and with $3656 left of the $5000 that you put aside (you made 12 payments of $112 from it towards the car)

However if you put down $5000 up fron on this car as a cap reduction by the end of the first year your payoff would be about $18,200. Since the car is worth $20,000 at this point and you owe $18,200 the insurance would pay the lender $18,200 and give you $1800. So you would end up with no car and $1800 in your pocket.

So if you compare the two numbers you can see that if your car is stolen or totaled after 1 year you would be losing over $1850 just because you put money down up front. This number would get smaller as the years go by, but you will be pretty much uspide down throughout the entire lease.

So even if you can't make 3% yield on your spare money it is still a good security to do a premiere purchase versus a conventional loan when the interest rates are so low and close to one another on the premiere purchase/lease and conventional loan.

In closing let me quote a really good investment advice:"Buy what appreciates,rent what depreciates". Cars are clearly depreciating faster than you can count, so they are never a good purchase.

[GTakacs]

Addendum #2

I have to get this through, because probably by now you already forgot!These numbers are working out because the residuals are high on german vehicles, and the interest rates and money factors are really low right now across the board. Cars that don't have high residuals are not as good of a choice for premiere purchase/lease as ones with high residuals. Also as soon as interest rates start to soar or the difference between conventional loan and balloon loan interest rates or money factors get bigger, conventional loan will start to make more sense again......

[tjl]

Quote, originally posted by GTakacs »

Let's say you're buying a car that costs $30K out the door and has an MSRP of $31K. It also has a residual value of 48% after 48 months. We assume 1.9% interest on the conventional financing and 2.25% on the premiere purchase. We also assume that you owe $20K in credit card debt that carries a 15% interest. Your total monthly budget is $1000 for the car payment and the credit card.

There is a huge assumption being made in your analysis: that someone who is carrying a $20,000 credit card balance (that can't be zeroed in one payment) is disciplined enough to use any car loan savings to reduce his/her credit card balance. Is that necessarily true for the type of people who have such huge credit card balances?

If the assumption holds true, then the whole thing boils down to paying down the highest interest rate loan fastest. Credit card interest is likely to be higher than car loan interest. On the other hand, someone in that deep a financial hole probably shouldn't be buying an expensive car and getting into even more debt.

[GTakacs]

Read my first Addendum. If you can find an investment that yields 3% or more, you're still better off doing a ballooon loan than conventional loan (ginve the interest rates and residuals of the example). The $20K credit card debt with 15% interest is clearly an extreme example, but I showed in the second post that this equation holds true for a lot wider range of debt/investment possibilities. And I figure people who buy $30K cars are wise enough to invest their money in something with a higher yield than 3%.

And let's not forget the fact that the bank estimated residual is rarely the true value of the car. And as long as the bank screwed up on the residual, you win on the premiere purchase.

Yes, there were assumptions, to illustrate the point, but the overall principle doesn't collapse just because not everyone's situation matches the one outlined in my extreme case.


Modified by GTakacs at 12:20 AM 6-24-2003

[tjl]

Quote, originally posted by GTakacs »

In closing let me quote a really good investment advice:"Buy what appreciates,rent what depreciates". Cars are clearly depreciating faster than you can count, so they are never a good purchase.

When you rent something that depreciates, your rent is paying for the depreciation, if the owner of the asset is smart enough to charge an appropriate amount of rent to compensate him/her for the depreciation. So you're paying for the depreciation either way, unless you buy an already well-depreciated used asset.

[tjl]

Quote, originally posted by GTakacs »

Yes, there were assumptions, to illustrate the point, but the overall principle doesn't collapse just because not everyone's situation matches the one outlined in my extreme case.

Really, the whole thing can be simplified to be, invest in the highest rate of return among several alternative with equal risk, or pay off the highest interest rate debt most quickly.

Of course, when risk is not equal, risk versus reward tradeoffs come into play.

[GTakacs]

Quote, originally posted by tjl »

Really, the whole thing can be simplified to be, invest in the highest rate of return among several alternative with equal risk, or pay off the highest interest rate debt most quickly.

And do you think if I wrote what you just wrote people would believe that Premiere Purchase is a better option than buying? I took the time to make up the above complicated example to illustriate this simple principle that a lot of people don't/can't understand if you just give it to them without actual figures. But you are correct, that is the gyst of it, I just figured I'd ellaborate on it a little more.

Quote, originally posted by tjl »

Of course, when risk is not equal, risk versus reward tradeoffs come into play.

EXACTLY. However buying a car and betting on it's future value is a risk. With the current used market being so weak it is a huge risk and I rather pay a bit of a premium in interest rate (assuming I don't have higher interest debt or I can't invest with a higher yield) and elliminate that risk.
Also hoping that the car will not be involved in an accident in the first 4 years of ownership is a risk. If it gets totaled during the first year and you're buying with a hefty down payment you can be out of a lot of money (read the addendum about lease with a large down payment, same applies to loans or balloon loans).

So these risk factors tilt the scale towards leasing/balloon buying even more. Again, this is my opinion only, I think putting as little money as possible into such a volatile asset as a vehicle is the best option.

[Double-V]

Balloon loans are a terrible idea compared to financing and leasing. I like to say that that balloon loans are the worst of both worlds. You are paying interest on the entire principle, not just the amount you use like a lease, so unless the interests rates between balloon loans and leasing are dramatically different (which they rarely are), then people pay too much.

[GTakacs]

If you live in an unlucky state like TX (amongst many others) you pay sales tax on the entire purchase price of the car whether you lease or buy or premiere purchase. I happen to live in such state so for me balloon loan makes perfect sense.

With the balloon loan, there is no need to pay first month's payment in advance, no security deposit, no bank fee to put down so it makes it a lot cheaper alternative than leasing regarding up front cost (and in overall in the states where sales tax is assessed on the entire purchase price regardless of terms)

Also, there are states where every manufacturer is pulling out of with leasing due to some vicarious liability that makes the bank liable if the car is in an accident given that the bank is the owner of the vehicle. In these states you will not be able to lease any vehicle in the near future, only balloon purchase.

So while in general lease might work out better for you, look at all the angles before you label balloon loans a terrible idea in general.

Also, the information I have posted above works with leases just as well as it does with baloon loans, I just found it easier to use balloon loan in my example instead of a lease (See the topic title)

[PA_Dub]

Quote, originally posted by GTakacs »

Also hoping that the car will not be involved in an accident in the first 4 years of ownership is a risk. If it gets totaled during the first year and you're buying with a hefty down payment you can be out of a lot of money

I don't really understand why you'd be out more money if you have a large downpayment vs. financing the whole car if you get totaled. The payout from the insurnace should be the same right? So it's either take the loss (down-payment) or pay off the remaining balance (finacing whole sale price). I'm probably just overlooking something. Can you give more explanantion? Thanks

[GTakacs]

Quote, originally posted by PA_Dub »

The payout from the insurnace should be the same right?

WRONG!

The thing that you're overlooking is that if you purchase/lease a vehicle with zero down you will be "upside down" in the car for several years (with a lease or balloon it's the entire term actually) which means that you would owe more than what the car is worth. So if your car gets totaled in this "upside down period" then the insurance company will pay your fair market value and the difference between the fair market value and what you actually owe will also be picked up by gap insurance. On lease it is mandatory, on a loan it is HIGHLY recommended to get gap coverage, my insurance company (Progressive) offers lease/loan payoff insurance.

If you buy the car with a substantial down payment or you lease wits serious cap reduction, you're elliminating being upside down, so the gap coverage will not come into play, since the car's fair market value will be higher than the payoff balance.

For more information just read my post above in this thread where I copied a previous post regarding this situation, ilustrating it with actual numbers. It was for a lease, but it works out the same for a conventional loan as well.

[PA_Dub]

Yes, I am well aware of the concept of being upside down, believe me. However, I wasn't aware of insurance covering the negative equity after the car has been totaled. I'll take a look through my records to see if I have that or if I need to get that added to my coverage.

[Double-V]

Quote, originally posted by GTakacs »

If you live in an unlucky state like TX (amongst many others) you pay sales tax on the entire purchase price of the car whether you lease or buy or premiere purchase. I happen to live in such state so for me balloon loan makes perfect sense.

I, and many others, however, live in states or provinces where this is not the case. In my province, balloon loans are a tax on the financially unaware.

[Double-V]

Quote, originally posted by GTakacs »

So if your car gets totaled in this "upside down period" then the insurance company will pay your fair market value and the difference between the fair market value and what you actually owe will also be picked up by gap insurance. On lease it is mandatory, on a loan it is HIGHLY recommended to get gap coverage, my insurance company (Progressive) offers lease/loan payoff insurance.

Again, this shows the danger of assuming that the regs are the same everywhere. Gap insurance doesn't work like that in Ontario, IIRC. And it is darn expensive to get for a 48-minth period.

[GTakacs]

Quote, originally posted by Double-V »

I, and many others, however, live in states or provinces where this is not the case. In my province, balloon loans are a tax on the financially unaware.

But you still pay bank/lease fee, security deposit and first month's lease up front, don't you? Premiere purchase is as easy as sign and drive with no money down which makes it a nice alternative. And unlike you, who blatantly ignores the fact that there are other states who are not as "fortunate" as your province, and lease might not even be an option to them, I know that lease can be a better deal for some states. Bottom line is: run the numbers on both premiere purchase and lease and see which one works out better. For example for a guy in Florida, a 39 month premiere puchase on an A4 would cost him $10 more a month than a lease.

Quote, originally posted by Double-V »

Again, this shows the danger of assuming that the regs are the same everywhere. Gap insurance doesn't work like that in Ontario, IIRC. And it is darn expensive to get for a 48-minth period.

There is no danger of assuming anything. Do you have a different GAP insurance on a lease than on a premiere purchase? If so, then again, lease might be a better option for you. If lease has the same restrictions on GAP coverage as premiere purchase then it's a moot point, both are a bad/risky option for you.

Let's not turn this thread into a "premiere purchase is bad, lease is good" thread, it was intended to be a "premiere purchase AND lease can be better than conventional loan for a lot of people". Use common sense and quit the nit picking, you're preaching to the choir dude, you have yet to tell me anything new.....

[GTakacs]

Oh, and not to make it into a Canada basher thread, but until I see "advice" like this one coming from Canada, I'll just keep my european/southern mindset......