I’m often asked by clients whether they should pay for their car using cash savings or fund it via a lease.
One theory suggests that you should not use debt to fund personal-use (depreciating) assets. This relates to the good-debt versus bad-debt principal. That is, if you use debt to purchase a depreciating asset you exacerbate the cost of the asset because it will include depreciation and interest also. It is generally accepted that cars depreciate by about 15% p.a. – but of course it depends on the make and model.
An alternative theory relates to the opportunity cost of the money tied up in a car. That is, if you didn’t use your cash savings, what else could you do with the money? For example, you could deposit it in an offset to reduce interest and risk (cash buffer), invest it, use it as a deposit for another investment property and so forth. The more money, the higher the opportunity cost. For example, if a car costs $20,000, there is not a lot extra you could do with that and paying cash is less of a concern. However, if the car cost is over $100,000, that equates to a deposit for an investment property for example – so the opportunity cost is higher. My view would be that you could put that money to better use and generate a return in excess of what a lease would cost you.
Therefore, in summary, generally the higher the cost of the car, the more I prefer to fund it using a lease. However, there are three provisos to this advice:
- I feel that you should match the repayments to avoid any negative equity. For example, if you calculate that your car will depreciate by say $10,000 p.a. and the interest cost of the lease is say $5,000 p.a., then my advice would be to repay $15,000 p.a. or about $1,250 per month. I feel it’s best to pay for the depreciation as it happens.
- If your cash flow is tight you may be better off paying cash to reduce your monthly expenses and thereby maximising your investable surplus cash flow. You want to avoid the situation where having a lease (because of the repayments) prevents you from making additional investments (if additional investments are necessary). Securing your financial future should be more important than upgrading your car.
- Of course the above advice is general advice only. You need to consider your risk profile, cash flow, business use of the car (if any), opportunity and necessity to make other investments and so forth.
If we can help you in any way with the decision of how to pay for your next car, don’t hesitate to reach out to your advisor.
