There seems to be a movement with “copier dealers” to prefunding a year’s worth of aftermarket in lease agreements. In this scenario the leasing company pays you 12 months of service and/or supplies that are bundled into a lease and discounts this revenue by 6 percent. I have had many dealer principals tell me that it is a great advantage because “it is effectively what I pay to borrow money at the bank only it doesn’t affect my bank lines of credit.”
These folks mistakenly believe they are paying an effective 6 percent interest for their money, but that is a gross miscalculation.
I’ll keep it simple before getting into the actual finances of the calculation. Let’s assume that the annual aftermarket in a lease is $2,000, meaning your prefunding is $1,880: $2,000 * 0.94 = $1,880 and 1.00 – 0.06 discount rate = 0.94 factor.
So you receive a check on day one for $1,880. If you took a loan out for this same amount at a 6 percent interest rate you’d make monthly payments of $161.80 and pay a total of $1,941.66 over the 12-month term. But you paid $2,000 and you didn’t pay the “interest” over 12 months, you paid it all upfront.
So big deal, you “lost” $58.44; you can afford it. Now let’s say prefunding is really attractive to you and you don’t have one contract with $2,000 in annual aftermarket prefunded, but rather $200,000 over hundreds of contracts.
For that $200,000 you received $188,000 on day one. If you truly paid 6 percent annual percentage rate (APR) for your money your total payments over the next 12 months would be $194,165.87. If you paid 11.6 percent APR your total payments would be just about the $200,000 that you paid to get your $188,000. But you paid the entire interest nut upfront so you actually paid an APR of 16.67 percent.
We’ll use a $1,000 loan as an example. With a normal loan you borrowed that $1,000 and 30 days later you pay a 6 percent APR on the outstanding balance, for the first payment that balance is $1,000, plus a proportionate pay down of the principle, or $83.33 for a 12 month loan. So for payment one you’d owe ($1,000*0.06/12+$83.33) or $88.33. Once the payment is made you’d owe $916.67 on your loan.
For the next month you’d owe ($916.67*0.06/12+$83.33) or $87.91. Most loans would have an equal payment with less going to principle at the front end and more at the tail end so your APR would be slightly higher than 6 percent, maybe 6.2 percent, but I’m sure you understand the calculation at this point.
You need to calculate cash flows to calculate the interest rate when you get a discounted sum of money at the front end of a transaction. Here’s the mechanics of you discounting your aftermarket payments.
For payment one you discounted 6 percent for 30 days use of the money. Had you not taken the discounted amount you would have received your first payment 30 days after the lease started. Therefore in simple yet not completely accurate terms (It would be an even higher interest rate), you are paying 6 percent for one month or 72 percent annually. For the second payment, which you would have received 60 days from initiation date, you are paying 3 percent per month (6%/2*12) or 36% annually. The third payment 24 percent (6%/3*12), the fourth payment 18 percent (6%/4*12) and only the last payment are you actually paying in the neighborhood of 6 percent interest. Welcome to the 16 percent club.
You could always argue that I am not taking into consideration what happens with the money the dealer gets from prefunding. Maybe it allows the dealer to pay cash-with-order and receive substantial discounts on their cost of goods. We could use the example of 5 percent CWO net 30 and make the statement the dealer is borrowing at about 16 percent yet making 60 percent on their money (if you didn’t take the 5 percent CWO you’d be paying 5 percent for 30 days, or about 60 percent annually). If you could not borrow money at lower than 16 percent and you truly were using the money specifically for this purpose it would be a smart move. But it would be hard to believe that you couldn’t borrow at lower than 16 percent when prime rate is 3.25 percent. Credit cards are probably cheaper.
I have many friends in the leasing space and they are an extremely valuable part of the dealer ecosystem. The goal of this post is not to disparage leasing companies as they provide valuable services. The goal of this post is to educate the dealer on their cost of funds so that they can make intelligent decisions on how to finance their business. Only by understanding your true cost of money can make intelligent business decisions.
