Financing Incentives – Do the Math

No money down! No payments for one year! 0% interest! Too good to be true? Let’s just start by stating “there is no free ride” and if it sounds too good to be true there is probably a catch. But what should the consumer do and how does one understand the underlying costs behind these enticing deals?

A little history behind the “no money miracle” helps to lay the groundwork for understanding the motives behind these offers. Over ten years ago the major automotive manufacturers began heavily marketing “the monthly payment” as the hook to get you into one of their products. Leasing provided a means for the public to move upscale without impacting their cash flow. It all made sense from a financial perspective. Pay only for the portion of an automobile that you consume. If under normal conditions you estimate a car will last eight years but you are planning on disposing of it after three, you can structure your lease to effectively pay only for the depreciation that accrues in the first three years.

The problems with leasing however have proven to be twofold. First, the consumer, attracted by the low monthly payment, often will find them self “upside down” on a lease. This means that when they are ready to trade their car they have not built up any equity and may actually have to reach into their pocket just to fulfill their original commitment. The second problem is more systemic in the industry. The monthly payment tells the consumer very little about their actual costs. Interest charges can effectively be hidden by playing with residual values. Over the past few years, governments have moved to put an end to this practice and are imposing regulations that obligate the industry to reveal the actual cost of financing.

The response by the industry has been to provide low cost financing, no money down offers and delayed payments but to give up nothing on the original cost of the vehicle. What sounds more attractive? For a limited time save $3,000 off of the $30,000 list price or 0% interest. The reality here is that the manufacturer is seeking $27,000 for the car. Let us face it, nobody pays list price for a Ford Taurus when they are paying cash. The imbedded interest is added to the $27,000 bringing the price up to the published MSRP of $30,000. Let us further assume that the 0% interest rate is offered over a three-year term. While you have been lured by the offer of 0% interest, the effective interest rate is 7% reflected in the additional $3,000 you pay over the term of the agreement. If you bought the car for $27,000 and borrowed the money from your bank at 5.5% you would have saved $660. This is summarized as follows:

Regardless of 0%, 1.9% or 3.9% financing, the economics work in the same way. This is not to say that the best deal is always to turn your nose at the manufacturer’s incentives. Let us go back to the example and assume that the discounted cash price is $28,000 or MSRP less $2,000.

Effectively, the manufacturer’s incentives provide an imbedded interest rate equal to 4.8%. Here we would be better off by $420 if we took the 0% offer rather than the $2,000 discount. The underlying message here is that you have to work through the numbers to fully understand the deal. Some basic understanding of the economics and your own analysis may save you hundreds, even thousands of dollars in the long run. Just remember: No money down, don’t pay a cent events are seldom what they may appear to be.

Mike Williams, MotorTestMagazine.com, holds an MBA degree from Wilfrid Laurier University, a Post Graduate MBA specializing in Finance from York University’s Schulich School of Business and a Masters of Taxation from the University of Waterloo.

Got Questions? Ask Mike: mike.williams@motortestmagazine.com