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Understanding car and asset finance

2003-04-07 10:18

John Oxley

About 50% of all car purchases in South Africa are financed through the banks via what are called finance houses.

The four leading players, alphabetically, are

  • ABSA Vehicle and Asset Finance Division, a division of ABSA Bank.
  • NedCredit, a division of NedBank.
  • Stannic, a division of Standard Bank.
  • WesBank, a division of First Rand Bank.

The rest of the purchases are bought for cash, about 85% by large corporates who use lines of credit with banking institutions, or their own funds.

How do these finance houses operate?

The prime business of a finance house is to lend money, and to receive payment for that service in the form of "interest"on the loan.

Unlike a bank, which lends money for all purposes, a finance house concentrates on the financing of moveable assets, the most common being a car, which is in most households the second biggest purchase after the home.

How is interest calculated?

Firstly, the banks determine an "interest rate". This rate is expressed as a percentage of a loan. A loan is also known as the"capital amount".

The interest rate is calculated by using what is known as "repo rate" - the rate at which the banks borrow money from the Government's Reserve Bank - and adding a percentage.

This percentage depends on what is known as your "credit worthiness" - whether you are a good or bad risk for the bank.

A good risk will be someone who already has fixed assets, such as a house, and who has a good banking record - in other words, has not had problems with overdrafts or bad debts.

A bad risk is someone who has no assets, or who might have had banking problems.

A "good risk" usually pays a lower interest rate than a bad risk.

The banks have a measurement which they call "prime rate" which is the interest rate at which they lend to a "good risk". Prime rate is the repo rate with a percentage added by the bank to cover its costs and a margin of profit.

As a rule of thumb, a person who owns a house, has a good banking record and a steady job can often get between 1 and 2% lower than prime rate.

You can often negotiate with the finance houses at the time you apply for a loan to get a better rate than that offered.

Remember that car dealerships get commission from the finance houses for arranging finance through them, so they cannot be relied upon to get you the best interest rate, since the amount of their commission depends on the level of your interest rate.

The higher the interest rate you pay, the more commission they get.

Loan period

Obviously the length of time you wish to borrow the money influences the total amount of the loan.

The longer the "loan period", the more interest you pay, although in normal circumstances the interest rate will remain the same.

If you were to borrow R1 000 over a year at 10% pa, and you repaid with one payment at the end of the year, you would pay a total of R1 100.

However, if you repay this loan on a monthly basis, as usually happens in a "finance agreement", then the total interest you are paying is less than in the above example because you are repaying part of the loan and part of the interest every month

For instance, if you borrow R1 000 at an interest rate of 10% for 12 months, you will pay a total of R1 055. So your monthly payment would be R88 x 12.

If you borrowed R1 000 at an interest rate of 10% for five years (60 months), you will pay a total of R1 275. So your monthly payment would be R21 x 60.

If you repay the loan in less time than initially agreed upon, you will pay less interest.

However, beware.

In the beginning of the repayment period the monthly payment you make is mainly used by the finance house to pay off interest, and only a small amount comes off the capital amount. On top of that finance houses often levy a fee or penalty to compensate for additional administration costs.

So you may not get back as much as you calculate you should if you pay off the capital amount early.

Linked rate

Another factor that comes into play is whether or not you "link" the interest rate agreed upon to the prevailing prime rate.

Quite often, if the prime rate appears to be dropping, then it is in your best interests to link to the prevailing prime rate so that when it drops, so the interest rate YOU will be charged also drops, and your monthly payments are reduced.

However, you must also realise that if the prime rate goes up, so too will your monthly payments.

If the interest rate appears to be climbing, it is often better to opt for a "fixed rate" set at the time you take out the loan, and not linked to prime rate.

Residual value

A final factor which might come into play is what is called a "residual value" .

No matter how old a car is, it always has SOME value, especially when the rate of inflation in the country is high.

As a rule of thumb, this is around 40% of the original purchase price after four years (48 months), and this is known as the residual value.

So, if you pay R100 000 for a car, after four years it will be worth R40 000.

If you finance it over four years, after making your 48th payment you are, therefore, the proud owner of an asset worth R40 000.

This value is sometimes used to bring down the monthly payments for a vehicle.

You might be persuaded that because the residual value is R40 000, you should only pay the finance on R60 000, then make a "residual payment" of R40 000 to pay off the balance.

You will pay for this residual value by selling the car.

This means your monthly payments (at an interest rate of 10% pa) will come down from R2 536 per month to R1 855 per month.

The dealer will probably try to persuade you that the actual value of the car will be MORE than R40 000, so you will make some money out of the deal.

He may even offer to purchase your car at the end of the period for an agreed price.

Whatever, it becomes a risk for you - you are gambling that the actual value will be more than the residual payment.

Or if you have a residual value guaranteed by a dealer, that the dealer will still be in business when it is time to sell.

The good news is that often the finance house is willing to re-finance the residual so you carry on paying for the car, but at a much lower monthly repayment since the capital amount is now much lower.

What this method means is that you are basically merely paying for the USE of the car, with, perhaps, a small payment at some time that can go towards your next vehicle.

Why use this method?

Usually this would be used by a business user whose prime objective in buying a car is to have the use of it. In fact it may be more tax effective to finance the car this way.

Best you check with an expert, though, to make sure the car you wish to buy will have a sufficiently strong residual value to make the deal less of a gamble.

Different types of financial agreement

The most common type of finance agreement is an "instalment sale agreement", previously known as "hire purchase".

An instalment sale agreement is a contract of between 6 and 60 months whereby a customer, also known as the "credit receiver" acquires use and ultimately ownership of an asset.

The asset - car - remains the property of the finance house until the final instalment payment is made to the finance house, at which point ownership reverts to the credit receiver.

From a tax perspective, SARS allows the business user to depreciate the asset according to an appropriate formula, usually 25% per annum over a four year period.

The business user may recover the full value of VAT paid at the time of purchasing the vehicle provided that it is a commercial vehicle used in the production of income.

Financial lease

A "financial lease agreement" is a contract of between six months and 99 years whereby the customer, also known as the "lessee" acquires use of the asset for the duration of the agreement in return for a monthly rental.

For practical purposes, motor vehicles are usually financed over a period not exceeding 60 months.

At the end of the agreement period, the customer may acquire ownership of the asset, usually in return for the payment of a nominal sum to the finance house (also known as the "lessor").

This is particularly suitable for a vehicle purchased for business use. Subject to approval by the SARS, the customer will be allowed to offset monthly rentals against income. There is no VAT benefit to the business user with this type of agreement. Only the lessor will enjoy a VAT benefit.

Rental agreement

A "rental agreement" is a contract of between six and 60 months whereby a customer acquires the use of the asset in return for a monthly rental.

When the rental period ends the asset is simply handed back to the finance house.

Strictly speaking the customer may never own a rented asset, and SARS will allow the business user to offset monthly rentals against income.

The business user may claim a VAT input credit on each monthly rental, provide that the vehicle is a commercial vehicle used in the production of income.

Full maintenance lease

A "full maintenance lease" agreement is similar to a rental except that all or most of the costs of maintenance of a motor vehicle are included in the monthly lease/rental fee.

This has extra advantages for a business or business user since all running costs, with the exception of fuel, can be factored in so there are no hidden surprises.

A full maintenance lease can personalised to suit each customer's needs.

Disclaimer: Wheels24 cannot be held responsible for any errors or omissions which may occur on this page. Readers are advised that this information may be subject to change without notice, and should therefore only be used as a guideline.

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