What’s the effect of interest rates on whole-life costs?
The Bank of England’s base rate hovered at a mere 0.1% just under two years ago.
Today, it stands at a staggering 5.25% – the highest it has been in over 16 years. This dramatic surge, driven by efforts to counteract inflation triggered by the pandemic, the Ukraine War, and the market’s turbulent response to the Liz Truss Mini Budget in 2022, marks a significant shift in the economic landscape.
Why is this important?
Some recent interest rate rises were necessary to calm the market after last year’s Mini Budget. In typical fashion, the Bank of England raised rates to tackle inflation. While inflation is now at 4.6%, its lowest since 2021, it had reached a high of 11.1% and was 10.5% at the beginning of this year.
Usually, increases in inflation, and consequently interest rates, will affect companies’ profitability, reducing the profit made on every pound invested in the business. For example, if the cost of petrol increases, a supermarket must spend more to transport goods to the stores, which decreases the profit made on the goods when they’re sold. When costs go up, most companies raise their prices to cover these higher costs and recoup lost profits.
As prices rise, the Bank of England will raise interest rates to increase the cost of borrowing as it seeks to rein in consumer spending to stifle demand and thereby encourage companies to reduce prices. As the cost of borrowing increases, companies will pay a premium for the money they have borrowed; this will affect companies that buy their fleet cars as well as the funders that buy cars to lease.
What’s the impact on whole-life cost calculations?
Whole-life cost calculations will be affected by both the higher inflation and the increased interest rates.
As their costs increase, manufacturers will increase the prices of their cars, which will filter into increased monthly rentals charged by leasing companies. But, increased interest rates must also be reflected, driving up finance rentals even more for those who lease their cars.
But, as we’ve noted above, higher interest rates also affect those who choose to buy their cars should they borrow money to do so. Just two years ago, with interest rates being so low, we did not include finance costs within the whole life cost of buying a car; this generally delivered a breakeven cost of capital around 1% to 3%, which essentially meant a company would begin to see the financial benefits of leasing a car if their return on investment was above 1%.
But as interest rates crept up and lease rentals increased, the breakeven cost of capital derived from Gensen’s lease or buy comparator has risen; this means higher interest rates have apparently made leasing less financially viable. But is that the right conclusion?
Well, actually, it’s not; when a company uses money to purchase a depreciating asset like a car, it denies itself the opportunity to invest in its business and generate a return on that investment. As a company’s return on capital increases, leasing assets such as cars should become more financially viable as the money otherwise spent to purchase cars would generate a greater return if invested in core activities.
To rebalance the equation, therefore, we have added an interest rate feature within the customisation options within Gensen. This new feature allows the user to set the rate charged on funds borrowed to purchase a car, as shown in the image.
This new feature allows the user to set the rate charged on funds borrowed to purchase a car
We have set the default rate at the current Bank of England base rate of 5.25% and will amend this whenever the Bank announces changes.
We acknowledge that commercial rates do vary, so we’ve allowed users to change the interest rate, just like they can vary other factors such as depreciation, VAT recovery, and cost of capital. And, if your customer doesn’t need to borrow money to buy a car, you can simply set the interest rate to 0%.
These two examples reflect just how significant this change was; if interest is not included in the cost of buying the car, the breakeven cost of capital is 4%, but with interest set at 5.25%, the breakeven cost of capital is just 1%, which is more in line with our expectation that leasing is more cost-effective than buying when the cost of capital lies between 1% and 3%.
Where are we now?
Recent reports suggest that the Bank of England base rate should begin to fall in mid-2024, ultimately stabilising in 2025; as such, there could be an ongoing impact on whole-life cost calculations of cars in response to the falling interest rates, and, hopefully,, a continued reduction of inflation.
But what does this mean for consumers? Ultimately, suppliers could have a price war as they strive to stimulate demand. We are already seeing this happen in the banking sector as mortgage rates are falling as major lenders bid to offer the lowest rate. Black Friday now seems to be a week-long event, and in some cases, discounts are being applied throughout November.
Price cutting has already begun in the car industry, too. Tesla further reduced the entry price of the Model 3, now a shade under £40,000, and the company is expected to release a smaller electric car, rumoured to be around £25,000.
As the electric car market finds different ways to settle in the new and used marketplaces, and the usual manufacturers meet the challenges of a growing number of Chinese EV suppliers, we’re supposed to be amazed that, suddenly, cheaper new electric cars are possible! Soon, we will welcome the (estimated pricing) Citroen e-C3 at £21,000, Kia EV3 at £26,000, and the Fiat Panda at £23,000. Who knows, maybe Vauxhall will stumble upon some ‘production magic’ and narrow the nearly £13,000 price gap between the Corsa EV and ICE base models.
Chagrin aside, we expect more manufacturers to follow suit and continue strengthening the value proposition for their electric cars. Less cost, more range and faster and simpler charging are the headlines of public demand. Let’s hope the UK and EU strike a deal so that rules of origin-related tariffs don’t drive up prices from January 2024.
This article originally appeared on Broker News, 22nd Nov 2023.
