Leasing versus Borrowing: Evaluating Alternative Forms of Consumer Credit
Nunnally, Bennie H., Jr., Plath, D. Anthony, The Journal of Consumer Affairs
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.
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. …