Leasing and home financing buyers beware
By Fuzail Zubaid Ahmad
A few days back, a friend came to my office on cab. I asked him where was his own car, he said that was stolen after he had paid off 24 out of 36 installments to a bank that he had leased the car from. I asked him what happened to the insurance claim, to which he replied that the insurance terms negotiated by the bank were such that he got a meager amount from the insurance company that was not enough to replace his previous car that was stolen. He was cursing his luck, but I cursed him for not asking me at the time he was signing the lease contract.

At that time, I decided to write this article. I urge all those people who are considering the option of leasing cars and home appliances, or even a home buying loan, to read this article, to avoid making mistakes at the lease contract signing stage and repenting later. (For home buying, it is not leasing but housing finance, but fundamentals are pretty much the same).

With increasing amount of liquidity available with them, banks and leasing companies are fiercely competing with each other in the field of consumer durables financing through leasing. Many people are getting attracted towards these financial institutions to upgrade their lifestyles. These people must understand a few things before they sign loan contracts with leasing companies, banks and housing finance companies, because it's a human nature to largely ignore future problems if today's loan is upgrading his/her lifestyle. The points to consider are as follows:

1. Interest Rates: There are two simple ways to describe the interest rate embedded in the repayment stream. One is, total repayment minus original loan, divided by the original loan, and result again divided by number of years in which repayment is to be made. This is a highly erroneous way of calculating the embedded interest rates, and gives a much smaller interest rate figure that unnecessarily impresses an unsuspecting person. Many times, enthusiastic sales persons would not even consider all payments from you, but only loan installments to calculate this rate. (Hey I got it at 5%. Not possible sir, check again!)

A company contacted me a few years back, which had taken some Rs.1.5m from a leasing company to buy assets on lease. The rate I saw was 39%, but the leasing company had told them it was 19%. Get the point? Obviously the company was very unhappy with this leasing company and to settle the score, they demanded and got much favorable terms on next few leases, because I was advising them.

Many unscrupulous (I would dare say) sales persons of financial institutions use this method to impress the buyers of vehicles and home appliances. Please always take the repayment schedule to a friend (preferably MBA with finance majors from a good business school) and ask him/her to give you the Internal Rate of Return (IRR) embedded in the repayment schedule. Double-check it with the sales person of the financial institution. There is a great likelihood that this sales person him/herself would give you the IRR that has been used, but don't take chances.

These days the IRR on new auto-leases is between 9.5% to 14%, depending on some other hidden costs that are explained later in this article. For used cars, it may be a little higher. On consumer durables, I have heard the IRR being charged is a little higher, which it should be. For home loans, 12% flexible IRR is in the market and 14% on fixed basis.

2. Advance rentals: Some financial institutions ask you to pay one or a few monthly or quarterly rentals in advance. Don't think even for a second that this is not important. It can impact the actual IRR. My personal experience - a sales person from a private bank gave me the IRR that did not factor in the fact that the repayment schedule asked me to pay two advance rentals.

3. Rentals at the beginning of each month (or quarter) or at the end: This is important too. Sometimes, sales persons knowingly or unknowingly ask you to pay advance rentals but give you an IRR that considers each installment/rental at the end of each month or quarter. This gimmick ups the actual IRR.

For these three point above, make sure you get the expert advice on IRR from a friend who asks you the entire cash flows, even the document charges, or any other fee. Not only that, the time you pay the money is also important for IRR calculations.

Another caution specifically for home buying; many banks are offering a lower IRR if you agreed to keeping the IRR flexible and not fixed. Because this flexible IRR is lower than fixed IRR option, many people accept it without realizing that interest rates in Pakistan are at their lowest these days and from here these can only go up. See what I mean? Ask an expert for second or third opinion.

4. Insurance Policy: Financial institutions will always ask you to either let them insure the vehicle or home appliance, or ask you to do it. The insurance policy is to be drawn in their name, and endorsed in your name. The insurance premium is the additional cost of leasing that you will have to bear. Yes for a new or used car, which can be stolen, you would like to go for insurance, but for a home appliance, insurance policy may seem like a financial burden but this is how it is.

The thing that you have to take care about, is that insurance policies bought by financial institutions on your behalf, may be to your disadvantage, while the financial institution is safe. One of the major insurance related issues is that the sum insured is less (sometimes far less) than what you would like it to be. As a result, in case of theft or other means of total loss, the insurance company would pay a far smaller amount that would only keep the financial institution happy. You may ask why would the financial institution not insure the total value and only a smaller portion. Well the answer is, and it may sound silly but its true, to make you feel happy because you have to pay a smaller premium.

Here is my personal example. I asked a bank why is it insuring my target car for 650,000 when its value is 730,000. The sales person had no clue and unknowingly referred me to his insurance company. I learnt from there that even though it would like to insure that car for 730,000, the bank's policy was different and if I accepted it would be disadvantageous to the insurance company because it would be deprived of a higher premium from me. And I was at a disadvantage in case that car was stolen or highjacked away. The insurance company would have only paid 650,000 and I would stand as the main loser.

I went back to the salesman of the bank. He said my query surprises him because most of his customers would try to get as small value insured as possible to save on premium. Please note, the right insured amount is best for you so far as vehicle is concerned. But if is a home appliance that would rather not insure, it wouldn't bother you but I urge you to be bothered because insurance protection is a must. I am not going to go into why some financial institutions do this, but you should mind your own interests. Many financial institutions don't mind protecting your interests too, but you have to find them to enter into lease contract with. Also be mindful that the first year's insurance you are going to pay up front and with each installment, you will pay a part of the next year's installment. Make sure you understand this mechanism so that you don't end up paying more.

My advise. Look for financial institution that allows you to have a lease deal that works best in your interests. Many financial institutions will force you to agree to their recommended insurance company, perhaps because they earn a little bit extra.

5. Down Payment: Financial institutions will ask you for anything ranging from 0% to as much as 30% or even higher, upfront. My advice, pay as much as possible, because your installment size will diminish. The IRR calculation will automatically adjust for your down payment, and make sure it does. A higher down payment means smaller monthly or quarterly installments. If down payment is substantial, if you can afford it, say 50% or even more, the financial institution should charge a smaller IRR. Look for a financial institution that will give you the benefit of paying 50% or more upfront.

A higher down payment protects financial institution in case you default. The asset will be taken over by the financial institution and would be sold in the market. First the remaining loan principal outstanding would be settled and then the remaining amount if any, would be given back to you. On the lighter side, if you intent to default, make sure you pay as small a down payment as possible, but if you don't, then pay as high as possible to avoid interest payments embedded in repayment schedule.

6. Termination Value Table: At the time of signing of the lease contract, make sure you pay some attention to analyzing the Termination Value Table provided by financial institution. Many people pay scant attention to this aspect, and when they want to settle the lease before the end of the contract, they learn that they were foolish not to have looked at this table closely as the beginning.

TVT gives you the value of lease termination value at any time during the tenor of the lease contract, and it diminishes after each installment. However, sometimes these figures don't diminish as fast as you would like them to be, which means that, say, after paying 12 installments you want to settle the lease payments in one lump sum payment. The leasing company would ask you to pay a higher amount than what you will expect. Make sure you understand how this TVT is drawn, by seeking expert advice from a friend. Believe me, some financial institutions are really harsh here, and have you agree to a TVT that penalizes you hard for prepaying your loan before the stipulated expiry of the lease tenor.

Only this morning a CEO of an active leasing company showed me a TVT that was perfectly made, but I know some financial institutions that do otherwise.

Because of excess liquidity with financial institutions, I don't blame them for harsh TVT's. They have to penalize their loan customers for repaying early, because they don't have good options to re-deploy their funds.

If you think these things are too confusing, contact someone who can help you get the best deal from financial institutions. Please don't lease anything expensive for which you can't afford the monthly or quarterly installments. This is the starting point of all troubles - borrowing more than what you can repay together with interest. After you have figured that you can afford monthly installments, please do consider all the above points and make sure you take expert advice. Don't accept anything that you will repent about, later. I know this business of leasing, but sometimes I make mistakes too, just because of overconfidence in my capabilities. A second (and even a third) opinion is an absolute essential.

I would like to say a few things about personal loans as well as credit card loans. Make sure you use credit card loans if there are no other options available. For personal loans, try to negotiate a a line of low cost credit and keep it unutilized to fall back on in terms of emergency. The best is to save, invest the savings in an open-ended equity mutual fund, like I have done, instead of buying shares yourself.

Ask the mutual fund management to arrange a credit line for you and use the units as security/collateral. This is the best thing to do for a person who knows that borrowing from your own savings (or by using your own saving instruments as collateral) is the best rather than borrowing from others' savings. Defer your vehicle/appliances/home buying plan, till you have established a good saving record. You can either encash your savings and pay up a good down payment for a lower IRR on your loan, or use your savings as collateral to negotiate get a better IRR.

A final point; I am not implying that financial institutions are cheating people through various techniques. They do many things as per policy that considers many aspects that you will perhaps not understand. All I am saying is that you must try to get the best deal - your right. If you have signed a contract that was not best for you, make sure you only curse yourself and not the financial institution because you had an option not to sign up at the beginning.

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